Rethinking Risk Tolerance for Retiring Clients

The traditional approach to evaluating the risk tolerance of retiring clients has some problems, according to Michael E. Kitces, director of research at Pinnacle Advisory Group.

He notes that most advisors probably use questionnaires with 15 or so questions to evaluate a client’s risk tolerance. The questionnaires ask about such things as when the client needs to withdraw assets; what other assets the client has; the client’s knowledge level about investments; and what the client would do if markets declined. The client gets a total risk score based on his or her responses.

These questionnaires are asking three different things. First is risk capacity, or the capacity to take risk based on the ability of the investor to absorb losses without getting wiped out. Next is risk perception, or what does the client actually define as risky investment behavior. Last is risk attitude or tolerance, based on considerations around how the client feels about risk/return tradeoffs, whereby taking risk means there could be a bad outcome or there could be great gains.

Kitces said there needs to be some way to account for the difference between risk capacity and attitude, separating time horizon and income needs from people’s willingness to trade off. “For example, we tell young folks, ‘You’re young, you should take more risk,’ but we don’t even ask if that’s going to make them nervous.”

A high risk capacity allows for any risk attitude, but a low risk capacity requires a high tolerance, he added. Risk attitude defines the upper limit of risk to take.

Risk perception presents another problem. Kitces said it seems clients have high risk tolerance in good markets and low tolerance in bad markets. But the problem is not that their tolerance changes, he warns. The problem arises when clients start thinking a short-term market trend is indicative of long-term results. This could lead them to misjudge risk and make bad decisions. Clients tend to remember most clearly what has happened most recently.

“This is where education and financial literacy matters,” Kitces said. “Advisors must do constant educating so client perception is realistic. Perception is something we can actually help clients with.”

However, advisors need to start separating risk capacity from risk tolerance, according to Kitces. “Just because someone may have a large portfolio or a long time horizon, we shouldn’t violate their risk tolerance and give them an overly risky portfolio,” he concluded.