When working with clients and determining a proper risk strategy for their financial plan one of the most important aspects is determining their “risk profile” (sometimes referred to as their risk tolerance). The risk profile is also beneficial for other aspects of financial planning and will often have some correlation with their financial personality, which I wrote about in a previous blog entry titled Financial Personalities.
So, what is a risk profile and how does it assist a financial planner in helping you with your financial plan? In short, a risk profile, and the questionnaire that helps an advisor determine the profile, is a tool used to determine how much risk is appropriate for a client’s financial plan and in other cases their entire financial plan. An advisor will use the information from the risk profile in helping them to create a recipe for proper investment asset allocation for the investment portfolio as well as give the advisor insights regarding their risk management tendencies, budgeting inclinations, etc.
What types of things does an advisor consider when constructing a financial plan using a risk profile? A good advisor will determine a client’s emotional tolerance for risk, their financial capacity for risk, and a client’s perception of risk. Some of the time these risk measurements come up with the same result, but a lot of the time they do not. I have seen circumstances where a client is very much against taking any risk with their investments because they fear they will lose their entire portfolio. Some of these same people could benefit by increasing volatility in their investment portfolio or risk not achieving their goals, or they are in a current position to take on more volatility and possibly increase the worth of their investment portfolio. When the different risk measurements conflict, this is where the value of a financial planner comes in. A good fiduciary financial planner can help a person determine where a good balancing point is between their differing risk needs and leanings. Just because a person should take risk and add volatility to their portfolio does not necessarily mean that they can handle this emotionally, and vice versa.
The three types of risk constructs are Emotional Tolerance for Risk, Financial Capacity to Take Risk, and The Individuals (or Families) Perception of Risk. Advisors should construct a risk profile questionnaire that will evaluate each type of risk constructs and ask follow up questions that will allow them to determine where a prospective client will fall within each of these risk disciplines. From there they should have an in-depth conversation with their clients that will allow them to better understand the sweet spot for taking risk. But what are each of these disciplines and how to they work with each other?
Emotional Tolerance for Risk will measure how someone feels about certain events that occur with their financial planning and their investment portfolio. How does a 15% downturn of an investment portfolio affect the mood of someone? How does a 10% rise effect someone? If there is a job loss how will this affect how someone feels about their investments and their financial planning? As stated earlier it does not make sense to have a highly volatile and risky financial plan if someone cannot emotionally handle the volatility, even if that is what they need to meet their goals.
Financial Capacity to Take Risk will measure how someone’s financial situation is situated to either add volatility or decrease volatility. What it does not mean or measure is someone’s need to take risk to meet the goals and objectives of their financial planning. That is done separately and generally involves a mathematic equation, but the results of the equation affect the capacity to take risk. If someone can meet their cash flow needs without touching their investment portfolio they might have a “high capacity to take risk”. Conversely, if the funds in the investment portfolio need to stretch out for a lot of years or the investment portfolio needs to start producing income right away this could lead an advisor to conclude this person had a “low capacity to take risk”.
The Perception of Risk by people can be greatly influenced by their Financial Personalities and can end up conflicting with reality. They may think that markets are risky or not risky but their perception may be way off. For example, if a person is a risk taker may think that if the market could crash, if something happens politically or if the Federal Reserve acts in a certain way, may in fact make decisions that they would not make based on their emotional tolerance or their financial capacity, because they have a misperception of risk. Because even though someone understands risk and is ok with risk emotionally they will not want to lose money in their portfolio and make an uninformed decision.
After establishing a client’s risk profile, how does an adviser then make recommendations that will be beneficial for the client? A good advisor will take the information that is gained and do an evaluation of the current financial situation, the desired financial outcome, and any anticipated changes to the current financial situation that may occur in the future. From there they will then devise a plan that will attempt to meet the needs of the client while considering the client’s views, insecurities, and appetite for risk. This plan will include cash flow and budget planning, risk management recommendations, tax strategies, investment portfolio recommendations, employee benefit optimization, and proper estate planning.
By regularly evaluating your risk profile and building your comprehensive financial plan accordingly will provide you with both balance and understanding about how a financial plan will react during times of downturn, excess, and mixed messages. Working with a financial planner who will help you walk through the process of a risk profile can greatly benefit you when building a cohesive financial plan as well as riding out the ebbs and flows that could be experienced.
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