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.
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
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.
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
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
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.
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.”
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.
here for the original article from Plan Advisor.