The importance of risk profiling in financial planning | Financial advisors
While investors tend to have their eyes fixed on the expected returns from their investments, responsible investing must also consider risk. Managing the trade-off between risk and return is the basis of successful investing.
Therefore, financial advisors tasked with helping investors achieve their financial goals must be mindful of risk. There are four key elements that every financial advisor should understand and always consider in the wealth management process:
- Risk capacity
- Risk tolerance
- Risk alignment
- Risk assessment tools
An individual’s risk capacity is the maximum amount of risk they are able to take given their current financial situation. In financial planning, risk here describes an investor’s ability to take on the risk premium of riskier or more volatile assets in pursuit of higher returns.
Various factors contribute to an investor’s risk capacity. One is the time horizon. For example, a 50-year-old man who plans to retire at 65 has a lower risk capacity than a 25-year-old woman who plans to retire at the same age. The latter has more years to spend on the market and can therefore assume more volatility, while the latter will have less time to spend and will not tolerate as much volatility.
Other factors affecting risk capacity include financial objectives, cash flow, revenue requirements, level of debt, insurance, and liquidity, among others.
Financial advisors should objectively determine each client’s risk capacity taking into account the above factors.
Risk tolerance refers to a person’s preferences for risk. There are risk averse, risk neutral and risk seeking investors.
Risk averse investors prefer low risk investments with lower returns to higher risk investments with higher returns. Risk-neutral investors focus on the returns they seek and will take all the risk necessary to achieve that, and that alone. Risk-seeking investors prefer high-risk investments with higher returns to low-risk investments with lower returns.
Financial advisers have categorized investors into three broad categories based on their risk tolerance: conservative, moderate and growth investors, roughly matching the risk-averse, risk-neutral and risk-seeking investors above .
Various factors determine an investor’s risk tolerance. These include age, income, financial goals, and other psychological and emotional factors. So, for example, 50-year-old investors are generally more conservative than 25-year-old investors, and high-income people are generally more willing to take risks than low-income people.
However, as noted above, psychological and emotional factors can also contribute to risk tolerance, so some 25 year old investors may be risk averse and some 50 year old investors may be risk seeking. .
Financial advisors need to understand their clients’ risk tolerance by considering both purely financial factors as well as psychological and emotional ones.
Risk alignment occurs when a person’s capacity and risk tolerance overlap. For example, if the 50 year old male above, who has low risk capacity, is also risk averse, then there is an alignment. However, if man is risk-seeking, then there is misalignment.
Misalignment can occur in two ways:
- A person with low risk capacity is risk neutral or risk seeking.
- A person with a high risk capacity is risk averse.
It is the responsibility of financial advisors to address risk misalignment. In the first case above, when a client has a low risk capacity with a high risk tolerance, the financial advisor can:
- Increase risk capacity to match risk tolerance: Suppose an investor who needs 80% of his retirement income and is 10 years from retirement nevertheless wants to invest more in stocks because he fervently believes in the potential of the market.
- Reduce risk tolerance to match risk capacity: Alternatively, the financial adviser in the above case can try to help the investor understand why too much allocation of their equity portfolio may expose the client to a return sequence risk. If the advisor is successful, the investor can agree to reduce their risk tolerance.
In the second case, where a client has a high risk capacity and a low risk tolerance, the financial advisor can:
- Increase risk tolerance to match risk capacity: Suppose a 25-year-old investor with high risk capacity prefers to load his portfolio with bonds rather than stocks. The advisor can help them understand the high returns equities provide and how they weather volatility and benefit from long-term capital appreciation.
The above examples are only illustrations that help to emphasize that the financial advisor should always seek to align each client’s risk capacity and tolerance.
Risk assessment tools
Risk capacity and tolerance are difficult to assess and risk alignment is difficult to achieve with inaccurate measurements.
Financial advisors can now get more accuracy by using various risk assessment tools. These tools are designed to help advisors understand each client’s profile and, therefore, how best to align both capacity and risk tolerance. Some of the best tools include Hidden Levers, Riskalyze, Finametrica, True Profile, Oxford Risk, and Tolerisk.
These tools help financial advisors determine risk capacity based on time horizon and financial goals, among others, and risk tolerance based on age, income, and clients’ answers to various psychological questions. and emotional. They also suggest steps advisors can take to align the two.
Risk will always be an important part of investment planning and portfolio construction. Financial advisors who want to excel must always consider risk capacity, risk tolerance and risk alignment. And they can be more successful in this task when they use profiling and risk assessment tools that will provide more accurate data.