Getting an accurate reading of each of your clients’ risk profile is key to providing the appropriate financial advice, says Geoff Davey, co-founder of FinaMetrica in Sydney, Australia, and an expert on psychometric risk profiling.
“Risk tolerance is only a small part of the advising process,” says Davey, who was in Toronto recently giving a seminar on risk tolerance, “but it’s a really critical part.” Davey defines risk tolerance as your client’s instructions to you about how much risk they are comfortable with in their investments.
Davey’s firm offers a 25-point questionnaire that helps advisors get an accurate reading of a client’s risk tolerance.
Getting a true reading of a client’s risk tolerance is a subtle art, because clients themselves often have an inaccurate idea of their ability to handle risk.
Many advisors end up with a distorted view of a client’s risk tolerance because they make one or more of these four common mistakes:
1. Asking questions informally
A casual discussion about risk is usually too subjective to provide an accurate risk assessment.
An informal interview about risk can make the client feel self-conscious, and result in clients trying to give the “right” answers. Companies such as FinaMetrica use psychometrics, a blend of psychology and statistics, to determine psychological factors such as risk tolerance, IQ and personality traits.
2. Having too narrow a focus
Make sure your discussion of risk covers all areas of financial services.
Focusing on just one aspect of a client’s finances can give an incomplete picture of a client’s risk tolerance, says Davey. For example, restricting your discussion to investment risk leaves other areas — such as borrowing, insurance and saving — neglected.
3. Confusing perception with actual risk tolerance
It’s easy to fall into the trap of mistaking a client’s perception of their ability to handle risk for their actual risk tolerance.
Most clients’ perception of what is a risky investment changes over time, says George Hartman, CEO of Market Logics Inc. in Toronto. But their actual tolerance of risk remains unchanged.
For example, during a bull market, equity investments may seem safe. But once equity markets dip, they suddenly seem much riskier.
When asking clients about their risk tolerance, says Hartman, frame the questions in relation to the realities of the current economic situation.
4. Doing a risk profile only once
Although a client’s risk-tolerance should not change, it’s still worthwhile to review it periodically to make sure it remains relevant in the context of changes in the client’s life and in the markets.
At a minimum you should revisit a client’s risk profile during your annual review, says Hartman. Talk to your clients more frequently if big changes occur in the markets between annual meetings. Hartman suggests discussing risk with your clients when there are extreme dips and gains in the market.
IE