Measuring a client's tolerance for risk is an essential (and required!) step when onboarding a new client, as making any sort of recommendation is impossible without first understanding how comfortable clients may be when their portfolios inevitably experience volatility. Over the years, 2 types of measurement tools have emerged as the standards for assessing risk tolerance: 1) psychometric tests, which feature a series of questions (such as, "What amount of risk do you feel you have taken with past financial decisions?") that are designed to measure risk based on past behavior, and 2) econometric tools, which involve questions based on a particular scenario (such as, "Suppose you can invest $100 and this time, there is a 50% chance you could receive $207 and a 50% chance you'd receive nothing. Would you agree to this investment?"). These tools provide critical insight into a client's preferences and attitudes, but as is the case with every subjective assessment, the results may not always reflect a client's true feelings about risk.
As many advicers have experienced, a client who might claim that they can tolerate a high level of risk may, in fact, behave quite differently during periods of higher volatility. The reality is that a client's true relationship with risk can only be partially uncovered through the results of a questionnaire alone. Like any other data point that an advicer may collect, there are stories behind the numbers, and the true power of a risk assessment is in its ability to help an advicer begin a conversation that encourages clients to share their stories. And when advicers take the time to listen to those stories, they begin creating long-lasting bonds with their clients.
And while few (if any!) risk assessment tools include suggestions on how to discuss the results with clients, advicers can use a series of questions to have meaningful conversations with their clients. To start, open-ended questions that use a command-style approach (such as, "Share with me what these results mean to you.”) can avoid setting an expectation that there is a 'right' answer. These questions also set the stage for follow-up questions that help advicers better understand if the client's main concerns around risk are focused on either fear of losing money or anxiety around missing out on growth potential.
From there, an advicer can ask how the client has reacted to prior bouts of market volatility. As while past behaviors can have a strong influence on current and future reactions, the advicer can peel back additional layers of the proverbial onion by exploring what (if anything) the client might wish they had done differently. Lastly (and perhaps most significantly), the advicer can ask (again using the command-style approach), "Tell me how I can best serve you when the market is rising and when the market is falling". Using this approach, the advicer can highlight one of the real values in a true financial planning relationship and start to set expectations around the working relationship as a whole.
Ultimately, the key point is that, while determining a client's risk tolerance is a critical step during the onboarding process and while developing an appropriate portfolio, the true usefulness of risk assessment tools lies in creating stronger bonds with clients. Because the opportunity for advicers to start meaningful conversations not only helps them understand their clients' true concerns, but also demonstrates the value of a real financial planning relationship while clarifying how they can best serve their clients!
