Many advisors are doing a poor job of assessing clients’ risk tolerance, and should be conducting more comprehensive risk profiling exercises in order to ensure they’re recommending suitable investments, according to Geoff Davey, co-founder and director at Sydney, Aus.-based FinaMetrica Pty Ltd.

Presenting at the Institute of Advanced Financial Planners’ (IAFP) annual symposium in Vancouver on Friday, Davey said assessing risk tolerance is a challenging psychological exercise, and it’s rarely assessed accurately.

“It’s not easy – you’re talking about trying to assess an aspect of someone’s personality,” he said. “Advisors really don’t have a very good understanding of their clients’ risk tolerance.”

Indeed, he pointed to a recent study of suitability by the Financial Services Authority (FSA) in Britain, which revealed a variety of shortfalls in the risk assessment and suitability processes of advisors.

“They found a whole lot of things wrong with what advisors typically did,” Davey said.

Such deficiencies also came into the spotlight during the financial crisis, Davey added. He said advisors who lost clients during the market downturn likely hadn’t properly assessed those clients’ risk tolerance, or had failed to communicate to clients the risks that they were taking on. All it takes is one major downturn for clients to realize they’re not comfortable with the risk they’re carrying, and often, this revelation causes irreparable damage to the advisor-client relationship, he added.

“Investment suitability with regard to risk is the key thing you have to do,” Davey said. “If you get that wrong, chances are, you may not have the chance to recover from it if the risk eventuates.”

A complete risk profile should include three separate risk parameters, Davey said: the client’s required risk – the amount of risk necessary to meet their goals; their risk capacity – the amount of risk they can afford to take; and their risk tolerance – the amount of risk they prefer to take.

After assessing these three measures, advisors need to identify mismatches between the three risk parameters and help the client make tradeoff decisions to determine the appropriate asset allocation and risk level to apply to their portfolio. Before implementing the asset allocation, Davey added, it’s critical to ensure the client clearly understands the risks involved.

Advisors make a variety of common mistakes in determining the risk profiles of their clients, Davey said. For example, he said many advisors assess a client’s risk tolerance, but ignore their risk capacity, which means they’re failing to consider the extent to which the financial plan can withstand the impact of unexpected events.

Another common mistake is for advisors to assume that since they’re comfortable with the risks associated with a particular investment, their client will be comfortable with it, too. Davey warns against making this assumption.

“Advisors on the whole are significantly more risk tolerant than their clients,” he said.

To ensure a proper risk profile, Davey urges advisors to be able to prove that they: know the client; know the product; have explored the alternatives; have explained the risks; and have obtained informed consent.

It’s also critical for advisors to be open with clients about the potential downside risks associated with any investment. He pointed to statistics showing that a portfolio comprised of 70% equities will, on average, be falling 36% of the time. Advisors need to ensure their clients are prepared for this.

“You ought to be able to avoid most unpleasant surprises for clients,” Davey said. “You can’t stop markets from falling, but they should be falling within your range of expectations.”