Getting an accurate reading of your clients' risk tolerance is fraught with challenges. But it is necessary if you are to assist your clients in meeting their investment objectives.
Failure could mean you wind up with disgruntled clients if their investment returns don't meet their expectations.
"Clients perceive risk when their expectations are different from what their portfolio delivers," says Roland Chalupka, chief investment officer with Fiduciary Trust Co. Canada, a subsidiary of Franklin Templeton Investments Corp., in Toronto.
Central to the challenge of understanding your clients' risk appetite is the fact that they almost always overestimate their level of risk tolerance, says Heather Holjevac, a certified financial planner with TriDelta Financial Partners Inc. in Oakville, Ont.: "Clients are willing to assume higher risk when the markets are doing well."
You may learn your clients' true appetite for risk only when they incur losses, notes Andrew Beer, manager of strategic investment planning with Investors Group Inc. in Winnipeg. That is when "they have a tendency to panic and ditch their long-term investments."
Such a scenario may reflect a misunderstanding of the risk/reward relationship on your clients' part. In general, the higher the risk, the greater the potential investment returns; the lower the risk, the lower the returns.
Because many clients do not have realistic views of their risk tolerance, the onus is on you to ensure that you have a comprehensive understanding of both the risk and each client's tolerance so you can guide your clients toward appropriate investments.
However, it's not simply a clients' tolerance for risk - the degree of change in their investments with which they are comfortable during varying market conditions - that you need to consider. You also should determine your clients' capacity for risk, which reflects the amount of risk they will need to take in order to achieve their goals.
The following client characteristics must be examined together so that you can devise a suitable investment strategy:
- Risk tolerance. Your clients' tolerance to risk typically is determined by using a questionnaire. This questionnaire is mandated by regulation, Chalupka says, and generally aims to place clients in one of three risk categories: conservative, moderately aggressive and aggressive.
This is a useful starting point, as it provides a broad indication of each client's risk profile. But to gain a deeper understanding, you'll need to use a variety of other, less formal methods.
"You must take the time to drill down," Chalupka says, "and understand what risk means to your client."