Advising clients on an appropriate asset allocation typically evolves from determining risk tolerance. Many advisors rely on risk tolerance software or questionnaires, but there is more to making a recommendation than merely using what the output says. Risk tolerance, in actually, depends on personal preference as well as return needs – and it’s not as easy as accepting a number from a program!
In discussions between an advisor and client, the client should address questions such as:
• Would you least prefer to see an investment increase in value after you sell it, or see an investment decrease in value after you purchase it?
• Would you least prefer to see your investments increase less than other investors’ portfolios in an up market, or see your investments decrease less than other investors’ portfolios in a down market?
• How much investment value decline can you accept on a weekly, monthly or annual basis before you would likely want to liquidate your portfolio and move to cash?
• Would you prefer a lower, more stable return or a higher return with more volatility?
Such soul-searching questions can assist a client in gauging his or her risk tolerance level. And, a live discussion can lead to clearer insight than depending solely on a questionnaire.
Once the client’s risk tolerance level is identified, his or her return needs must be established. A client’s return needs may be different than his or her wants. Since higher returns necessarily carry higher risk, in general, younger investors can more appropriately strive for “wanted” returns.
In an ideal situation, the expected return set by the risk tolerance level will be adequate to meet the client’s goals. However, if this return is not adequate, the client has two options:
• Accept a higher level of risk, or
• Modify goals to accept a lower expected return
Prior to the client accepting a higher level of risk, the advisor should quantify the impacts of holding a portfolio with such a level of risk. By quantifying potential declines in value, the client can more readily identify his or her true ability to tolerate risk. For example, if the higher risk level can mean a loss in value of up to 12 percent in a down year, can the client with a $1 million portfolio withstand a loss of $120,000? What if there is another bad year immediately following, resulting in another loss of $105,600? A client who cannot emotionally handle a higher level of risk must accept the need to modify his or her goals.
The bottom line is that risk tolerance quantification is truly more of an art than a science. Advisors need to follow best practices in terms of gathering information as well as thoroughly document support for recommendations.