Risk is the degree or percentage of possibility that something bad or unpleasant will happen. Ascertaining the appropriate level of risk for an investor is an activity that must be done prior to choosing investments or deciding on asset allocation. In this video, Dr. Michael Finke, CFP®, Chief Academic Officer at The American College of Financial Services, discusses risk assessment, client happiness, risk tolerance, and why people become more vulnerable to making investment mistakes as they age.
The Link Between Risk Tolerance and Risk Capacity
An investor’s comfort with risk is often seen as an aspect of their personality, but risk tolerance also depends on risk capacity, which in practical terms means an individual’s ability to experience financial loss and still attain their goals.
Several external factors influence an investor’s risk capacity. For example, the investor close to retirement with a small nest egg will have a different capacity for risk than a young investor with a well established portfolio padded by a inheritance. The client who is betting their mortgage has a different capacity for risk than one with ample disposable income.
How to Assess Risk Tolerance
The standard risk assessment tool is traditionally a survey or questionnaire. Some financial planning firms have risk tolerance questionnaires for their advisors to use with clients, but for those that don’t, reputable public sources, such as this risk tolerance quiz from Rutgers University, offer useful tools for assessing risk tolerance online.
Surveys such as these provide a measurable starting point for discussion. A financial planner can use questionnaire results as an opportunity to educate clients and open a wider-ranging conversation of the investor’s financial needs and goals.
Understand How Risk Perception Shapes Decisions
Learning how a client perceives risk is important because their attitudes color their decision making. Professional planners should run through a variety of scenarios and outcomes to educate investors about how to make choices that align with their risk tolerance and capacity.
For example, will the investor who perceives investing as inherently dangerous and prefers stable assets meet his or her financial goals if they choose investments which are safe but only deliver a low rate of return? How will the client who chooses higher risk for higher returns feel if the value of their assets decline precipitously?
Working closely with an investor to determine tolerance and capacity for risk is an ongoing process. It’s important to discuss risk regularly over the life of the planner-client relationship because risk tolerance and capacity change over time. For example, the older investor no longer actively working or earning an income tolerates a different level of risk than a younger individual who views retirement as a distant event.
Financial advisors who earn the Chartered Financial Consultant® (ChFC®) designation from The American College of Financial Services receive a comprehensive education that helps to help investors at all life stages make smart decisions. The ChFC® prepares planners to develop sound financial plans to meet clients’ unique goals.
Download our free white paper How the ChFC® is a Game Changer in Advancing Your Financial Planning Career to learn more about how earning a ChFC® helps planners serve investors better. You will gain insights on how to retain a loyal customer base, acquire new high-net-worth clients, increase earnings, and strengthen your reputation as a financial expert in a shortened time frame.
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