Should Your Clients’ Risk Profile Align With Their Risk Tolerance?
A suitable risk profile balances risk preference with the risk necessary to meet a particular goal.
Pop quiz: What’s the difference between risk tolerance and risk profile?
Risk tolerance and risk profile are often used synonymously yet are distinct constructs when determining suitable risk levels for your clients. On the one hand, our risk tolerance is a psychological trait—it’s how we feel emotionally about taking risk, which tends to be relatively stable over time. On the other, a risk profile describes the amount of investment risk that’s suitable in the pursuit of an investment goal.
Clients may have different risk profiles for different goals, whether it’s retirement planning, for example, or funding a child’s education. Each risk profile is shaped by:
- the investment objectives of the goal
- the circumstances related to the goal
- the personality of the client
Some components vary on a goal-by-goal basis. For example, a client’s capacity to take on risk and how much risk is required to achieve the goal are influenced by the amount of money needed, time horizon, cash flow, liquidity need, and whether the goal is high or low priority.
Other components are personal in nature and reflect an individual’s general underlying comfort and preferences across all investment goals. This includes risk tolerance, financial knowledge, investment experience, and nonfinancial preferences.
The investment risk profile is the aggregate treatment of all these components.
Balancing Goal-Related and Personal Components to Create a Risk Profile
Break down the process of developing risk profiles, so clients (and you) are not overwhelmed by all the moving parts.
Identify each component separately so they can be understood and compared. Goal-oriented components are best defined, stimulated, and stress-tested using robust cash flow modeling where possible. You can kick-start the process with a rough figure and build precision as the client gets comfortable discussing their goals and expectations. On the other hand, personal components like risk tolerance are best measured with validated tools for accurate and reliable results from the get-go.
Account for each component and bring them together in a consistent manner. Effective trade-offs can only be made when the components can be compared on the same scale. Ensure you have a framework for how you map the personal components to the goal-oriented components and be able to demonstrate impact and consequences. For example, how might you demonstrate to clients the impact of low risk tolerance or other adjustments for personal preferences? You want to be confident the framework is defensible and can be applied across different scenarios.
Clarify options, illustrate potential outcomes, and facilitate trade-off discussions. Toggling between different balances of personal and goal-oriented components means clients will be faced with multiple possible risk profiles. Conflicts between alternatives and differences within households are best solved with what-ifs or scenarios modeling. Visualizations can help clients engage with different possibilities and stay committed to the agreed plan.
How Risk Profile Can Differ From Risk Tolerance
Let’s consider a client with a high tolerance for risk who has three goals: an education lump sum due in three years, retirement living expenses in 15 years, and a “nice to have” boat purchase in five years. This simple scenario illustrates the possible range of suitable risk profiles for a single client when their portfolio is bucketed for specific goals.
In each case, the client’s risk tolerance is on the high side, but the capacity for risk varies with the circumstances. The short time horizon for necessary education expenses calls for a conservative risk profile for that bucket. A moderate risk profile is appropriate for the retirement bucket. And an aggressive risk profile might be suitable for the boat bucket, even considering the short time horizon because the goal is low priority.
Alternatively, an aggregate risk profile could be assigned to the whole portfolio by considering how the various components average out across the portfolio.
In any case, it’s prudent to confirm any discrepancies between risk tolerance and risk profile selection with clients. Though clients may need to take on more risk than their risk tolerance assessment indicates, advisors must ensure that clients are doing so knowingly, alternatives have been considered, and not so much risk is being taken on that the client is likely to panic in a major downturn.
By helping clients develop risk profiles that reflect both them and their goals, financial advisors can help clients reach those goals and stay committed to their financial plan throughout the process.
