When working with an individual client, a financial advisor should consider the client’s willingness and ability to take risk. Every situation is different: some wealthy clients may be risk averse, while those with fewer assets may be hungry for a chance at high returns.
An appropriate portfolio must take into account both the will of the investor and aptitude take some level of risk. It is essential that these two criteria are met. It is also necessary for the investor to understand the nature of the risks and the possible consequences.
Key points to remember
- Financial advisors are responsible for recommending investments that match the client’s willingness and ability to take risk.
- Risk tolerance measures subjective aspects of risk tolerance, including a client’s personality, how they react to actual or potential losses, and what their goals and priorities are.
- The capacity or aptitude to take risks measures objective factors such as time horizon, age, need for income and family situation.
- Financial advisors sometimes use questionnaires or surveys to create a risk assessment for each client.
- Risks are inevitable in investing because higher returns are associated with higher risks.
Understand the risk
In finance, risk is defined as the likelihood that the actual outcome of an investment will differ from expected returns. When creating a portfolio, an investor (and their financial advisor) should understand the risk factors associated with each type of asset, as well as any unknown factors that may also come into play.
Although risk is inherent in the market, not all risk is created equal. For example, fixed income instruments such as bonds are generally considered safer than stocks, but a blue chip stock may be less risky than a poorly rated junk bond.
Risk tolerance vs risk capacity
Risk tolerance is often confused with risk capacity, but the two concepts are quite distinct from each other. Perhaps the easiest way to understand the two is to think of them as opposite sides of the same coin.
For individual clients, risk tolerance is closely related to the age of the investor. Young investors can afford to take on more risk, while those approaching retirement tend to choose less risky investments.
Risk tolerance
When a financial advisor discusses a client’s risk tolerance, the advisor is determining the client’s mental and emotional capacity to manage risk. This means understanding and respecting the level of investment or financial risk a client is comfortable with, or the degree of uncertainty the client can bear without losing sleep.
In general, risk tolerance tends to vary depending on each client’s age, financial stability and investment objectives. Advisors sometimes use questionnaires or surveys to better understand how risky an investment approach should be.
The opposite of risk tolerance is risk aversion. If an individual would rather miss out on potential gains than risk losing money, that client is relatively risk averse. Conversely, if a person expresses a desire for the highest possible return and is willing to endure large fluctuations in portfolio value to achieve this, that person is risk seeking.
The riskiest investments are off limits to retail investors, but sometimes they have the highest returns.
Risk capacity
The other side of the coin is the ability to take risks, or the ability to take risks without jeopardizing the client’s long-term goals. This is a little more objective than risk tolerance and can be determined based on the type of assets in the client’s portfolio.
The financial advisor should review a client’s portfolio, using financial metrics to determine how potential losses will affect the client’s bottom line. The risk capacity is limited by several aspects such as a client’s potential need for cash or quick access to cash, as well as how quickly the client needs to achieve their financial goals.
Risk capacity is assessed through a review of assets and liabilities. An investor with many assets and few liabilities has a great capacity to take risks. Conversely, an individual with few assets and high liabilities has a low capacity to take risks. For example, someone with a well-funded retirement account, ample emergency savings, and no debt likely has a high capacity for risk taking.
Types of risk
The most well-known types of risk are those that can be measured directly. For example, the likelihood of a winter storm affecting shipping or crop yields can be reliably calculated, based on observational evidence.
Other risks are more difficult to quantify: there is no reliable way to gauge the likelihood that lawmakers will pass a new trade restriction or that stocks will enter a bear market. Yet even an imperfect understanding of these dangers can help investment professionals choose the best assets for their clients.
Here are some common sources of risk and mitigation strategies:
Liquidity risk
Liquidity risk refers to the risk that the client will have to withdraw their short-term assets. It’s not always a necessity, but most investors still find it comforting to know that they are able to cover sudden or unexpected costs.
Liquidity risk varies between different investments. For example, a financial adviser may advise private equity investments for clients who are less concerned with quick access to cash, which allows for the potential for significantly higher returns. On the other hand, liquidity-conscious clients would benefit from investing in exchange-traded funds (ETFs) and large-cap stocks, which can be easily liquidated at their fair market value.
Market risk
Market risk is the danger that asset prices will fall, either due to lower investor expectations for a certain asset or as part of a broader downturn. The dot-com bubble and the Great Recession are classic examples of market risk, as even top-rated stocks suffered as prices fell.
Market risk can be mitigated by diversifying its portfolio, particularly among uncorrelated assets. This does not eliminate market risk, but does reduce the likelihood of all assets in a portfolio going down at the same time.
Regulatory risk
Regulatory risk refers to the danger that the government will take coercive action against a certain company or sector, causing prices to fall. This risk is particularly pronounced in the banking and technology sectors, where several large companies have been accused of violating antitrust laws. Cryptocurrencies also face significant regulatory risk, and it is unclear which digital assets qualify as unregistered securities.
What are the risks of employing a financial adviser?
Although investment advisers are strictly regulated, there are concerns that some financial advisers do not have the best interests of their clients in mind. For example, some advisors may earn a commission on the sale of certain investments, or they may be paid on a per trade basis, giving them a monetary incentive to recommend trades that may not be warranted. In other cases, an advisor may give good advice that doesn’t justify their high fees. These concerns can be allayed by considering a fee-only advisor or by researching to make sure your advisor is a fiduciary.
What is risk management in finance?
In financial matters, risk management is a process of identifying, measuring and reducing the uncertainties associated with investing. Risk is an inescapable element of the financial world since the highest returns come with the greatest risks. By learning more about the risks associated with a particular investment, an advisor can determine whether that investment is suitable for a specific client’s risk assessment.
What are the least risky investments?
Historically, fixed income securities tend to have the lowest risk, such as government bonds and highly rated corporate bonds. However, these also tend to have much lower returns than other assets. While equities tend to outperform bond markets, they are also riskier. This risk can be somewhat mitigated by investing in an ETF that tracks the market rather than individual stocks.
The essential
Financial advisors are entrusted with their clients’ most valuable assets, often representing decades of savings. However, there is no one-size-fits-all solution when it comes to investing. Only by carefully studying each client’s financial situation and risk preferences can an advisor help their clients create a portfolio that truly represents their clients’ best interests.