How Advisers Can Gauge Risk Tolerance

Attitude is important for investors and their advisers in times of economic stress and market volatility.
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As a financial adviser it's your job to do your best to understand your client’s risk tolerance and to factor this into your investment strategies. One of the truest tests of a client’s tolerance for risk is their reaction to a period of sudden decline in the stock market such as the one we’ve experienced due to the coronavirus pandemic.

Risk tolerance questionnaires are a good tool to use with new clients, but they only go so far. Over time, as you get to know your clients you will gain a greater sense of their comfort with the risks that come with investing.

During periods of steep market declines as we’ve experienced recently in the wake of the COVID-19 pandemic, it’s important to discuss your client’s feelings about the market decline, while listening carefully to what they are saying about those concerns and perhaps what they aren’t saying. By this we mean being alert for any underlying fears they may not be expressing to you.

How does your client define risk?

Talking with your clients can help you to understand how they define risk. Everyone likely would include the risk of losing money from their investments as a part of their risk definition. Beyond this basic definition, each client probably has different factors that influence their risk tolerance.

One factor could be tied to age. Clients who are in or nearing retirement may feel a bit more risk averse as they have less time to make up for major investment losses. Much will depend upon their individual feelings about risk plus their level of preparedness for retirement. Those who not only have sufficient savings, but also have decent levels of retirement income from a pension and/or Social Security might be feeling a bit more secure and less stressed about their investments.

Is your client feeling uneasy about their job situation? This is an especially relevant factor in light of the COVID-19 situation and its impact on many businesses. Some of your clients might be facing job losses, furloughs or some sort of reduced income. This can factor into their feelings about risk as well, especially if they would need to use some of their portfolio as a backup to cover for an income shortfall.

These types of situations and others can help shape the way your clients define risk. For many their investments are tied in with their life goals, if their investments suffer a major setback they may risk not achieving these goals.

Adding Value as an Adviser

There are various studies out there that discuss the value that a financial adviser can add to their client’s investment returns. Part of this involves the behavioral aspects of finance. It’s always important to take this part of the investing process into account when working with clients. Where possible, it’s important to do what you can to take the client’s emotions out of the investing and financial planning process.

As a financial adviser you likely have a number of processes that you use to put a client’s financial plan together, including the investment strategy that you feel best fits their plan and their situation.

The more you can get your clients used to working within the framework of a process, the less emotional they are apt to feel about significant moves in the stock market. This starts when you begin working with them and extends to regular interactions like periodic review meetings you might have with the client. It includes the format of the review meeting, how you communicate updates that might be needed to their financial plan or their portfolio.

Every client and their needs are unique and should be treated as such. As their adviser it’s important that you never lose sight of this fact. Not every problem has a routine solution.

Nonetheless, giving your clients the feeling that you attack issues that pertain to them using a refined process can in and of itself take the emotion out of unfavorable market situations. By taking this type of approach, you can help clients across the emotional spectrum take a more measured approach to dealing with risk.