Risk tolerance: Stated and real

Some clients are “news-oriented,” says Konrad Kopacz, investment advisor with Chippingham Financial Group Ltd. in Burlington, Ont. They may overreact to market developments. You have to keep them focused on their longer-term objectives.

Brian Smith, vice president and portfolio manager with Fit Private Investment Counsel Inc. in Toronto, suggests that there are two sides to client risk: risk tolerance and risk capacity. Risk tolerance, he explains, is what clients believe they are willing to do and involves their emotional makeup. Risk capacity, on the other hand, is quantitative in nature, involving the amount of risk that clients actually are comfortable in taking. “Separating the two,” Smith says, “is what makes the determination of risk tolerance challenging.”

Typically, the reported risk assessment – the know-your client (KYC) process – involves the use of a questionnaire required by your compliance department that “fits the client into a predetermined box: conservative, moderate or aggressive,” says Kevin Sullivan, chartered strategic wealth professional and vice president and portfolio manager in Toronto with Montreal-based MacDougall MacDougall & MacTier Inc.

This standardized approach is a good starting point in assessing your client’s stated risk tolerance, Sullivan cautions, but is not sufficient to assess real risk tolerance. This approach deals with issues such as client objectives, expectations, finances and time horizon. But clients are individuals who have different psychological profiles, which, , he suggests, limits the applicability of the KYC questionnaire.

The problem with the KYC process, says Holjevac, is that clients tend to overestimate the amount of risk they are willing to take. To put measured risk assessment in perspective, if you asked your clients about the level of losses they can tolerate and you frame the question in terms of percentage losses, clients will tend to overestimate their risk tolerance. However, if you ask the same question but expressing losses in terms of dollars, you are likely to get a different answer.

For example, a client may say that he or she can tolerate a 20% loss on a $100,000 investment, but you are likely to get a different answer if you asked whether the client would be able to tolerate a loss of $20,000 on the same investment.

In order to get a better handle on measured risk tolerance, Kopacz suggests painting different risk scenarios using visual demonstrations, which often are easier for many people to understand.

But even this approach is not always good enough. In that case, advises Smith: “You will have to dig deeper by using more informal methods.”

Holjevac recommends gauging risk by asking a lot of questions to achieve a better understanding of your clients. You must know your clients inside out in order to anticipate how they will react to market events.

Holjevac suggests that history might help. In the past, for example, a client might have invested in a certain way but then was dissatisfied with the results. This knowledge about this client’s past investing history can give you a good sense of that client’s risk appetite in the future.

Clients’ time horizons for achieving their investment objectives also is a key element to be considered, says Holjevac. She notes that clients with high risk tolerances but long time horizons may not have to take a lot of risk to achieve their investment goals. Conversely, Holjevac says, if a client has a low risk tolerance and a short time horizon, that client may need to consider whether he or she really wish to take more risk to achieve his or her goals.

Indeed, the appeal of playing catchup by taking more risk needs to be avoided by some clients, Holjevac says, if it involves more risk than these clients can realistically tolerate.

Kopacz cautions that when discussing risk, you must be careful not to influence your clients with your own views on risk. Sometimes, he says, there is a tendency to construct KYCs based on the advisor’s own risk parameters.

Often, you become aware of the difference between your clients’ reported and real risk tolerance only when those clients incur losses and try to switch their investments at the worst possible time. “[Clients] tend to overreact and their judgment becomes tainted,” says Holjevac, which leads to selling low and buying high over different market cycles.

At the end of the day, many clients are fickle when it comes to risk – whether stated or real. An investment policy statement, which fully documents your clients’ expectations, generally helps them to stay on track with their goals and keeps you on the right side of the compliance department.

Kopacz also documents all discussions, sends his clients a confirmation e-mail and requests their acknowledgement to ensure that they understand their investment decisions.

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