Advice needed on retirement income strategies, report finds

There is often a big difference between clients’ perceived risk appetite and their actual ability to handle risk. That’s why it’s important for you to help your clients take a realistic view of how much investment risk they can take. Otherwise, you can end up with disgruntled clients or lose them altogether.

“One of the biggest challenges in getting an accurate reading of clients’ risk tolerance is that they almost always overestimate how much risk they can tolerate,” says Ahad Ali, portfolio analyst with Octane Capital in Toronto.

“When markets are doing well, clients are willing to assume a higher level of risk,” Ali says. “But when things are falling apart, they become frazzled and head for the exit.”

To put risk in perspective, a client’s tolerance for risk represents the degree of change in his or her investments they can withstand comfortably during varying market conditions. The client’s capacity for risk is based on the amount of risk he or she needs to take in order to achieve their goals.

“The problem is that clients usually tell you that they can take a certain amount of risk but they really can’t,” Ali says.

So, to get an accurate picture of your clients’ ability to withstand investment risk you need to go through a thorough discovery process with them. Here are some steps you should take:

> Evaluate risk tolerance
Your clients’ tolerance to risk is usually determined by using the standard Know Your Client (KYC) questionnaire. The objective of the questionnaire is to place clients into one of three broad risk categories: conservative, moderately aggressive and aggressive.

While the KYC questionnaire is a useful starting point, Ali says, it is “mechanical” and does not necessarily provide a true measure of risk tolerance.

> Dig deeper
You have to go beyond the standard questions to find out what risk means to your clients, Ali says. Ask your clients to share their investment experiences with you. For example, a client might tell you why he or she was satisfied or dissatisfied with certain investments they made in the past. This can give you an indication of their comfort level with risk.

“You may wish to present them with different investment scenarios to get their reaction,” he says. “Or, ask the same risk-related question from different angles.”

If you frame a question in terms of percentage of potential losses clients can tolerate, you may find that they will overestimate their risk tolerance. However, if you ask the same question but express the potential losses in dollars, you might get a different answer. Clients might tell you they can tolerate a 20% loss on a $100,000 investment, but would provide a different answer if you asked whether they can tolerate a loss of $20,000.

> Balance risk tolerance and capacity
Knowing the time frame clients have for achieving their investment objectives is critical for balancing their risk tolerance and risk capacity, Ali says. The longer their time horizon, the more risk they usually can take because the market normally reverts to its mean performance over time.

But clients who have a high risk tolerance and long time horizon don’t need to take a lot of risk because time is on their side to achieve their investment objectives.

In order to help your clients understand the amount of risk they need to take, you may wish to use several model portfolios to demonstrate the risk/reward trade-off for various asset mixes. This would help them get a clearer perspective on why they may need to take more or less risk over their particular time horizon.

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