Tips for Assessing a Client’s Risk Tolerance

Assessing a client’s risk tolerance is crucial for any financial advisor. Many investors overestimate their ability to handle market downturns and sell their stocks at a loss in moments of panic. Alternatively, others are too inhibited to get into the market in the first place. Each person has a risk appetite that’s specific to them.

“Risk tolerance is a very capricious thing,” said David Demming, a financial advisor with over 40 years of experience and president of Demming Financial Services in Aurora, Ohio. Demming’s long experience with investors, he said, tells him that newer clients generally adjust their tolerance to where it will typically be for your time advising them.

Once they have been in their investments for more than a cycle, they understand the volatility involved, akin to learning the normal turbulence of flying after a few flights. Cautioning patience early on, Demming argued, is crucial. “Ultimately, it is gaining the experience and discipline of going through a full business cycle” that’s most meaningful since clients have “lived through it to see the reward” and can “settle down for the long haul.”

However, Demming was clear about the losses that can accrue for the advisor and client if a client refuses to be steered in a more prudent direction when their risk tolerance is involved. He wasn’t short on examples. For instance, from 2022 to 2023, Demming said, a new, risk-averse client was growing more anxious as news of post-pandemic inflation and other economic news rolled in. Eventually, in October 2023, he liquidated and closed his account with the firm. Soon enough, though, the market rebounded significantly—the S&P 500 finished 2023 up almost 25%—though the client’s portfolio presumably did not.

Another anecdote was a friend Demming advised during the Financial Crisis and the beginning of the Great Recession. The damage done clearly left a mark: Demming could give me the exact date, March 3, 2009, when his friend liquidated his accounts. From then until the year’s end, he said, the market was up about 50%, costing his friend about $1 million.

Below, we provide five tips for assessing your clients’ risk tolerance while keeping in mind Demming’s lesson that the market, too, can be a capricious thing.

1. Start With a Risk Questionnaire

For some, risk is simply the potential for market losses. For others, it may involve the dangers of losing a job, giving up income, or going without insurance coverage. Others frame risk in terms of opportunity costs: the investments they could have had. It’s an advisor’s job to tease out the client’s appetite for risk and how they frame their idea of losses before trading begins.

Advisors don’t always ensure they do so. “Too many times, we see prospective clients come to us with a portfolio that doesn’t meet their risk tolerance and goals because they were placed in a certain model portfolio years ago and never had it adjusted,” said Nate Creviston, manager of wealth management and portfolio analysis at Capital Advisors in Shaker Heights, Ohio.

Thus, advisors need ways to assess their clients’ appetite for risk from the get-go. Eric Kimbro, a certified financial planner with Stone Kimbro in Costa Mesa, California, said, “Risk tolerance questionnaires are a great starting point for understanding a client’s ability to handle risk and their attitudes around investment risk.”

Kris Etter, a principal at Beacon Financial Planners in Dallas, Texas, said his firm starts with a questionnaire but supplements that with the Retirement Income Style Awareness (RISA) tool developed by Retirement Researcher. He finds the tool especially helpful for those approaching or already in retirement.

RISA offers clients options to describe their thoughts and feelings about retirement income strategies. For example, Etter explained, a client may select a statement such as, “Committing to a more fixed strategy early in retirement protects me from a worsening economic environment” or “I value being able to consider my retirement income withdrawal options on an ongoing basis.” By incorporating these responses into his report, Etter can tailor his recommendations to align with the client’s risk tolerance and overall mindset as they enter and navigate retirement. Perhaps more importantly, Etter said, “The RISA also allows us to show the clients in their own words why we feel our recommendations will work for their financial plan.” In this way, clients see how Etter’s strategies match what they reported as their own risk tolerance. This ensures both are on the same page.

It does something more, he said. It “allows us to educate the clients on the importance of proper allocation (diversification) along with appropriate rebalancing to achieve their goals.”

2. Keep Going With Open-Ended Questions

Many advisors find they need to dig deeper with clients through more than just a questionnaire. “An open discussion about what thoughts came up as they were taking the assessment usually adds the necessary context required to settle on the right allocation for a client,” Kimbro said.

Creviston agreed, noting, “We use a few metrics to help define a client’s risk tolerance, but the main method we use is from open conversation.” Otherwise, he said, “You might miss that their risk-averse attitude comes from a family event that left them unable to tolerate risk; you might miss that they’ve taken a lot of risk in the past but have lost a lot of money due to red flags being ignored.”

He added that you also need to consider how much a client can put at risk financially, not just emotionally. “It’s also important not to forget to match risk tolerance with risk capacity,” Creviston said. Risk capacity concerns the amount a client can lose before it begins to affect their other finances: in general, the bigger the portfolio, the greater the client’s capacity for risk. Creviston cautioned that you can’t assume a perfect match between risk tolerance and risk capacity. Of course, there are times when no one has an appetite for what’s happening in the market. “Even if they have a large risk capacity but a low risk tolerance, they will never feel comfortable when their portfolio drops more than 20% during a bear market,” he said.

3. Factor in What Can Be Measured

In general, the longer a client can wait before dipping into invested assets, the riskier a portfolio can be. Higher-risk securities generally have a higher expected return, and the turbulent periods smooth out over longer time horizons. Hence, it’s crucial to account for what you can measure, even though personal risk tolerances often seem based on something idiosyncratic about each of us. These factors include the following:

• Time horizon and age: The length of time a client can wait before needing to access their invested assets plays a major role in determining their risk tolerance. Generally, clients with a longer time horizon (10 years or more) can afford to take on more risk, and clients with shorter time horizons should typically invest in less risky assets to minimize potential losses. As a general rule, portfolios of those closer to retirement should be weighted toward less risky assets like bonds, while younger workers can tolerate greater exposure to stocks.
• Income: The stability and reliability of a client’s income can also impact their risk tolerance. Clients with steady, predictable incomes will often accept more risk in their investments compared with those with variable or commission-based salaries. In addition, clients with higher incomes may have a greater tolerance for risk, as they can more easily replace potential losses.
• Children: Many of us know a carefree and spendthrift couple who suddenly buckle down to save once they have children. Familial obligations greatly influence, of course, a client’s risk capacity. Clients with partners and children may need to ensure they have more in short-term emergency cash while some savings go into a 529 account for their kids’ educational needs. As with their plans on weekend nights, those without children have more flexibility in their investment choices.
• Partners: Even when a couple is happily married, it doesn’t mean that they share a tolerance for risk. Every advisor has a panoply of stories about partners who hide money from each other and who have opposing tolerances for risk. The key is to ensure each partner knows you’re listening to them; your task is to help them reach their goals by allocating investments that allow each to sleep at night.

Each of these significantly affects a client’s ability to withstand market volatility and potential losses.

4) Assess Their Personalities and Values

This is where your open-ended questions and discussions while using platforms like RISA are most helpful. “Psychological components play a large factor in clients’ tolerance toward risk,” Creviston said. “Simply put, some are more comfortable taking risks if they know that mathematically, over long periods, they will outperform others who aren’t comfortable taking on risks. However, clients who are risk-averse aren’t wrong. They deserve to have a portfolio tailored to their comfortability and goals.”

Assessing a client’s personality and values is less quantifiable but equally important in determining how well a client can emotionally handle market volatility and potential losses. Here are some key aspects of this:

• Personality: A client’s overall disposition can provide valuable insights into their risk tolerance. Some individuals are more cautious and risk-averse, while others are more adventurous and willing to take on far more risk. These traits might come from long-ago experiences with money or from having gained or lost a substantial amount previously through investing.
• Reactions to actual or potential losses: You won’t have much direct experience seeing your clients in action early on. Nevertheless, they are usually quick to divulge how they would react to real or hypothetical market downturns. This can reveal their emotional resilience and ability to handle risk.
• Long-term goals and priorities: Clients prioritizing steady, reliable growth may be more comfortable with lower-risk investments, while those seeking to maximize their returns are typically willing to accept more risk.

Understanding a client’s aspirations and values can help you immensely as you consider their risk tolerance. Active listening and thoughtful questions will help you uncover your client’s underlying attitudes, fears, and motivations for investing.

5) Reassess Regularly

While much research has shown that most people don’t change their personal or psychological approaches to risk over time, that’s not to say that client appetites for risk remain static. What researchers have wanted to know is whether, all things being equal, they remain relatively the same, but that’s different from suggesting they don’t change when significant events occur in a client’s life.

Changing finances and shifting personal priorities all contribute to shifts in a client’s willingness to take on investment risk. As such, the advisors we spoke to said they regularly reassess their clients’ risk tolerance to ensure that their investment portfolios remain aligned with their comfort levels, not just their financial goals.

As Creviston put it, “It’s an advisor’s job to let … clients know the risks involved in being either too aggressive or too conservative. These portfolios also need to be revisited over the years.” Some common life events that may trigger a change in risk tolerance include the following:

• Marriage or divorce
• Birth of a child or grandchild
• Job loss or career change
• Retirement or approaching retirement age
• Health issues or changes in medical status
• Inheritance or sudden windfall

In addition, gradual shifts in financial circumstances, such as changes in income, debt levels, or savings goals, can also impact a client’s risk tolerance over time. To remain attuned to these changes, you should review any shifts in risk appetite during regular check-ins with your clients, ideally annually or whenever a significant life event occurs. If you find a change, you can work with your clients to adjust their investment portfolios accordingly. This may involve rebalancing assets, modifying investment strategies, or exploring other financial products.

The Bottom Line

Assessing a client’s risk tolerance is critical when creating and maintaining portfolios that align with their needs and goals. By understanding the factors influencing a client’s willingness to take on investment risk, you can better guide their strategies.

Measurable factors like time horizon, age, income, and family circumstances provide a basis from which to begin. You can then fill in less quantifiable aspects of their risk tolerance: personality, how they react to real or hypothetical losses, and long-term goals and values. As you discuss with clients the factors behind their appetite for risk, you also build trust that you take their comfort level with the hazards of the market seriously.

Researchers have generally found that clients’ reactions to risk don’t change much, but that doesn’t mean their risk tolerance remains static. Regular reassessments, particularly following significant life events or changes in financial circumstances, will ensure you and your client are on the same page about the financial path forward.