Assessing your clients’ risk tolerance and overall risk profile (which includes risk capacity, risk needs and behavioral biases) is essential to building suitable portfolios, running an efficient practice and meeting compliance requirements. But what is the ideal way to do it? Tip: It’s not just about having the best risk tolerance questionnaire.
First, let’s define “best”. In my eyes the best risk tolerance process is accurate, fast, inexpensive and pleasurable. Accurate means you can trust the results of your process. Fast means the client can be assessed in less than 30 mins (excluding advisor discussion). Inexpensive means the value should exceed the cost. Lastly, pleasurable means both you and the client should enjoy the process.
Having spoken to thousands of advisors over the years about risk profiling I can say the best risk tolerance process involves the following…
1. Client Education – It’s difficult to get an accurate result and for clients to enjoy the risk tolerance process if they don’t understand basic financial theory. As I explain in my email course “How To Assess Your Client’s Risk Profile” clients should understand the risk-return tradeoff, the importance of time horizon, and the skill of coping with uncertainty. Without some of these fundamentals, it will be difficult for a client to grasp any risk tolerance questions.
2. Use A Professional Risk Tolerance Questionnaire – This might sound self-serving but a professional questionnaire will improve accuracy and speed. It will also make the experience inexpensive, compared to the time spent asking clients questions and mailing/filing paper questionnaires. Creating your own questionnaire might seem like a good way to save money but you take a big risk on accuracy and speed. With online questionnaires prospects and clients can do it online before they come to your office. It’s very convenient.
3. Complete Annual Reviews – Clients change. Not overnight but typically as the years pass. It’s a good idea to track how your clients are doing every year.
4. Continuous Communication and Education – I am a big fan of newsletters for so many reasons. Chief among them is that they can serve as an antidote to the misinformation in the media. Slowly educating your clients over the months and years about financial markets will give them the mental wherewithal to deal with market corrections. I particularly like the newsletter produced by Lexington Wealth.
To conclude, as an advisor, you must appreciate the risk tolerance assessment process is always ongoing in the background. You can’t assess once and neglect it for years. Clients need to be educated and they undoubtedly change over the years (although this is likely to be slight). So as part of your annual reviews spare some time to discuss your clients’ risk tolerance and overall profile.