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.”
@page_break@ Holjevac recommends gauging risk through conversations. In certain instances, your client might have invested in a certain way but became dissatisfied with the results. This knowledge could give you a good sense of his or her risk appetite. Holjevac also suggests presenting different investing scenarios to discern a client’s response to risk.
Beer recommends a thorough interview to help you know the client better. “You must be able to ask the right questions,” he says, “from different angles.”
Adds Chalupka: “People tend to view risk differently when asked the same questions in different ways.”
If you ask your clients about losses they can tolerate, he adds, and you frame the question in terms of a percentage, clients will tend to overestimate their risk tolerance. However, if you ask the same question but express the potential losses in dollars, you often will get a different answer.
For example, a client may say that he or she can tolerate a 20% loss on a $100,000 investment, but you would get a different answer if you asked whether the client would be able to tolerate a loss of $20,000.
– Balancing tolerance and capacity. One of the key determinants in balancing your clients’ risk tolerance and risk capacity is the time horizon for achieving their investment objectives.
For example, Holjevac says, clients with high risk tolerances but long time horizons may not need to assume a lot of risk to reach their objectives.
In order to help your clients to understand the amount of risk they need to take, Holjevac suggests you use several model portfolios to demonstrate the risk/reward trade-off for various asset mixes. This step would help your clients to gain a more clear perspective on why they may need to take more or less risk over their particular time horizon.
However, Holjevac cautions, you might not be able to persuade some clients to take on more risk, especially if they are risk-averse. Or they might want to take on more risk than you believe they should, based on your assessment of their risk profile. This can put you in a tough position, she adds, in which you may have to decide whether you want to work with such clients.
Given that clients are fickle when it comes to risk, an investment policy statement (IPS), which documents clients’ expectations, may help them stay on track. The IPS should be reviewed regularly, Beer says, because “some clients have a short memory.”
In the Mid-February issue: How you can explain the uses of many different types of risk when building your client portfolios.
The first instalment in a three-part series on helping your clients understand risk
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