While investors tend to have their eyes fixed on the expected returns of their investments, responsible investing must also consider risk. Managing the trade-off between risk and return is the foundation of successful investing.
Consequently, financial advisors who are tasked to help investors achieve their financial goals must pay attention to risk. There are four key things that every financial advisor must understand and always consider in the wealth management process:
— Risk capacity
— Risk tolerance
— Risk alignment
— Risk-assessment tools
The risk capacity of an individual is the maximum amount of risk they are able to take on given their current financial circumstances. In financial planning, risk here describes the ability of an investor to take on the risk premium of riskier, or more volatile, assets in search of higher returns.
Different factors contribute to the risk capacity of an investor. One is time horizon. For example, a 50-year-old man who plans to retire at 65 has less risk capacity than a 25-year-old woman who plans to retire at the same age. The latter has more years to spend in the market and can, therefore, take on more volatility while the latter will have less time to spend and cannot tolerate as much volatility.
Other factors affecting risk capacity include financial goals, cash flow, income requirements, debt level, insurance and liquidity, among others.
Financial advisors need to objectively determine the risk capacity of every client by considering the above factors.
Risk tolerance refers to a person’s risk preferences. There are risk-averse, risk-neutral and risk-seeking investors.
Risk-averse investors prefer low-risk investments with lower returns over higher-risk investments with higher returns. Risk-neutral investors focus on the returns they are seeking and will take on any risk required to get there, and that alone. Risk-seeking investors prefer higher-risk investments with higher returns over lower-risk investments with lower returns.
Financial advisors have classified investors into three broad categories based on their risk tolerance: conservative, moderate and growth investors, corresponding roughly to the risk-averse, risk-neutral and risk-seeking investors above.
Different factors determine the risk tolerance of an investor. These include age, income, financial goals and other psychological and emotional factors. So, for example, 50-year-old investors are generally more conservative than 25-year-old investors and high-income earners are generally more willing to take on risk compared to low-income earners.
However, as said above, psychological and emotional factors can also contribute to risk tolerance such that some 25-year-old investors can be risk-averse, and some 50-year-old investors can be risk-seeking.
Financial advisors need to understand the risk tolerance of their clients by considering both the purely financial factors as well as the psychological and emotional ones.
Risk alignment occurs when a person’s risk capacity and tolerance overlap. For example, if the 50-year-old man above, who has low risk capacity, is also risk-averse, then there is an alignment. However, if the man is risk-seeking, then there is a misalignment.
Misalignment can occur in two ways:
— A person with low risk capacity is risk-neutral or risk-seeking.
— A person with high risk capacity is risk-averse.
It’s the responsibility of financial advisors to address risk misalignment. In the first case above, where a client has low risk capacity with a high risk tolerance, the financial advisor can:
— Increase risk capacity to match risk tolerance: Suppose an investor who needs 80% of their income in retirement and is 10 years away from retirement nevertheless wants to invest more in stocks because they are an ardent believer in the potential of the market.
— Reduce risk tolerance to match risk capacity: Alternatively, the financial advisor in the case above can try and help the investor understand why too much allocation of their portfolio into stocks can subject the client to sequence-of-returns risk. If the advisor succeeds, the investor can agree to reduce their risk tolerance.
In the second case, where a client has high risk capacity and low risk tolerance, the financial advisor can:
— Increase risk tolerance to match risk capacity: Suppose a 25-year-old investor with high risk capacity prefers to load their portfolio with bonds instead of stocks. The advisor can help them understand the high returns that stocks provide and how they weather volatility and benefit from long-term capital appreciation.
The above are only illustrations that help to highlight the point that the financial advisor must always seek to align the risk capacity and tolerance of every client.
Risk capacity and tolerance are difficult to gauge and risk alignment is difficult to achieve with inaccurate measurements.
Financial advisors can now achieve more accuracy by using various risk-assessment tools. These tools are designed to help advisors understand the profile of every client and, therefore, the best way to align both risk capacity and tolerance. Some of the top tools include Hidden Levers, Riskalyze, Finametrica, True Profile, Oxford Risk and Tolerisk.
These tools help financial advisors determine risk capacity based on time horizon and financial goals, among others, and risk tolerance based on age, income and client answers to various psychological and emotional questions. They also suggest steps that advisors can take to align both.
Risk will always be an important part of investment planning and portfolio construction. Financial advisors who want to excel must always consider risk capacity, risk tolerance and risk alignment. And they can be more successful at this task when they use risk profiling and assessment tools that will provide more accurate data.
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The Importance of Risk Profiling in Financial Planning originally appeared on usnews.com