Improving Client Experience Through Better Risk Tolerance Assessments

For many investors, the beginning of the year is a time for them to review their investing strategies and reassess their risk tolerance. Though the U.S. stock markets have been on an incredible run last year, recent polls of economists and American voters indicate great concern about a looming recession.

This means that advisors need to be in tune with the changing needs of investors and actively assess the risk that they are willing to take in a potential bear market. Inaccurate, confusing or outdated investment risk assessments could result in investors with unrealistic expectations and pose a major risk for financial advisors.

Risk Perception

Risk tolerance, which is an investor’s willingness to withstand variable investment returns, is only a small component of managing risk for clients. Investors may believe that they have a high risk tolerance and are able to handle downturns in the market, but they may not actually understand how to be prepared in a bear market. This is why advisors need to consider a holistic view of a client’s perception of risk. Goals should be evaluated frequently to ensure that investments match time horizons. Advisors should also assess the investors’ understanding of risk. Do they know what percentage of their investments are stable, and which may be lost in a market downturn? Although they may feel prepared to take risks while the markets are looking up, that perspective can quickly change when the market takes a dive.

Other risk determinants that should be considered by an investor are risk capacity and risk perception. Risk capacity relates to the amount of risk that the client can actually afford to take or needs to take to reach certain financial goals, regardless of their perception of risk. This capacity can change based on age or lifestyle factors, and it needs to align with an investor’s time horizons and goals. Risk perception is psychological, and refers to how an individual will actually process financial losses. Although investors may feel like they can and want to take risks, recessions create a very different risk assessment, as investors will see what these risks look like in actuality. Poor investment advice in a market downturn can result in legal liabilities for advisors and could turn investors away from the market completely.