Determining a client’s risk tolerance is a crucial part of generating a risk profile. But this must be balanced against an acceptable level of risk for a return on their investments.

It is a common misconception that risk profiles are ‘set and forget’. Instead, advisers should be working with clients on an ongoing basis to ensure their risk profile is both accurate and suited to their needs and objectives.

Retail investors often only associate risk with losing money and financial advisers may fall into the trap of assuming that client risk profiles remain fixed over time. For many, it has taken the COVID-19 pandemic and associated business disruption to clearly illustrate this point: market risk is not static; and a client’s risk profile shouldn’t be either.

Ryan Felsman, Senior Economist at CommSec, says it is a common misconception that risk profiles are set in stone. Ideally, advisers should be continually educating and working with clients to keep the risk in their portfolio well matched to their goals.

“The risk appetite of all investors changes over time. As part of their broader portfolio rebalancing strategy, advisers should be regularly reviewing their client’s risk tolerance and capacity levels, while adjusting their asset allocations accordingly,” he says.

“Like professional investment managers, financial advisers should consider diversifying their client’s investments across a range of asset classes, including styles – like growth and value – sectors, industries and geographies.”

Risk control

While risk profiling has traditionally been arrived at through client questionnaires and risk scoring, the introduction of psychometric risk tolerance testing and modelling software have enhanced many advisers’ risk profiling and benchmarking processes.

“Determining the client’s risk requirements, capacity and tolerance for risk are all crucial in generating a risk profile. Ultimately, the client often balances an acceptable level of risk for a required rate of return on their investments,” says Felsman.

However, it must be emphasised to clients that risk profiling and portfolio rebalancing – both key elements of the portfolio construction process – are designed for risk control, not return maximisation. Because risk and return go hand in hand, the starting point for any wealth creation strategy must be risk appetite, risk tolerance and the level of risk required for the client to reach their goals.

Studies suggest staying invested and avoiding panic selling during periods of high volatility and uncertainty are much easier when an investor’s portfolio has had the right level of risk for them from the start. And while there is no perfect science to the risk profiling process, technology such as psychometric risk tolerance testing and modelling software mean the tools at the adviser’s disposal are better than ever.

Psychological traits

Despite falling superannuation balances and stock valuations, some advisers have noted that their clients are far better prepared for volatility than they were in the aftermath of the Global Financial Crisis. Two reasons cited for this are regular communication with clients about their risk tolerance and better portfolio diversification.

The quest to deliver timely and relevant financial advice requires going beyond any questionnaire, and risk profiling should be seen as a way to facilitate an ongoing conversation. For example, a person’s risk tolerance is likely to remain stable over time while varying greatly over different areas of their life. An extreme example would be a conservative investor who enjoys high-risk hobbies like skydiving in their spare time.

Nicki Potts, a director of product management at Morningstar, says investor risk tolerance is like other psychological traits in remaining mostly stable over time and in varying market conditions.

“Most people do not change from being an introvert one day to an extrovert the next, nor does their risk tolerance change. Individuals largely test the same after a crisis as before.”

However, a client’s risk capacity can be influenced by major financial events throughout their life, such as an unexpected redundancy or a health crisis that leads to significant medical bills. These changes will likely lead them to revisit both personal and financial goals and their timeline for achieving them.