Private Clients Risk Tolerance

Risk tolerance: Refers to the level of risk an individual is willing and able to assume.

Risk capacity: Refers purely to the ability to accept financial risk.

Risk perception: This is an attitude toward risk.

Risk Tolerance Questionnaire

Risk tolerance questionnaires help a manager assess a client's risk tolerance, both in terms of capacity and perception. It should be thought of as the beginning of an effective client-manager relationship, and can often open the door for a beneficial risk tolerance conversation.

Some questions may be qualitative, such as:

In a financial and economic sense, I consider myself to be:

• Well-off.
• Comfortable.
• Struggling.

While others may be more quantitatively oriented, such as:

If my portfolio were to decline by 20% in one year, I would:

• Sell all investments.
• Buy more while prices are low.
• Do nothing.
• Initiate a conversation with my wealth manager.

Examples of effective questionnaires can be found all over the internet. Competent wealth managers should consider the questions being asked in the firm's standard questionnaire. They should be able to glean more insight into the client's perceptions of, and abilities to tolerate risk. They should be relevant to the work the wealth management firm does. For example, if derivatives comprise a large portion of many client portfolios, this theme should be touched upon in the questionnaire. An example question could be:

Derivative investments are:

1. Risky and dangerous.
2. Versatile portfolio management tools.
3. Something I am not familiar with at all.

Risk Tolerance Conversation

A risk tolerance conversation can ideally go above and beyond a simple questionnaire. A productive conversation offers the opportunity to uncover client details in a more dynamic way. While many conversation themes may be personal and unrelated to finance and economics, they should of course, eventually inform the manager about the economic aspects of a client life. These themes include but are not limited to:

• Relationships with family and friends.
• Formative client experiences.
• Past investment mistakes and successes.
• Source of wealth.
• Whether the client thinks of investment losses in absolute or percentage terms.

Conversations about risk tolerance are opportunities for the wealth manager to educate the client about investment risk. For example, a wealth manager may demonstrate how certain risk factors can produce incremental returns as well as incremental losses (the part clients hate to think about, and often forget). A wealth manager may ask a client to select from a “menu” of portfolios with a range of expected returns and degrees of volatility. This menu provides some insight into an individual's risk tolerance based on his or her choices.  

Question

After administering and reviewing a client risk tolerance questionnaire, it is discovered that the client has high liquidity needs, and a 10% loss in portfolio value over one year would seriously compromise the client's investment plan. This is best described as a fact related to client:

1. Risk tolerance.
2. Risk capacity.
3. Risk perception.

Solution

The correct answer is C.

Risk perception refers to how the client views and understands financial risk. The fact that the client believes a 10% loss in portfolio value would seriously compromise their investment plan reflects their perception of risk.

A is incorrect. Risk tolerance is the client's psychological ability and willingness to take on financial risk. It's related to their comfort level with the ups and downs of their investments. If the client has high liquidity needs and a 10% loss in portfolio value would seriously compromise their investment plan, it suggests that they have a low risk tolerance because they are not comfortable with significant investment losses.

B is incorrect. Risk capacity relates to the client's financial ability to absorb losses without negatively impacting their financial goals. The fact that a 10% loss in portfolio value would seriously compromise the client's investment plan indicates that they have a low-risk capacity. This is because their financial situation may not allow for significant losses without adverse consequences.

Portfolio Construction: Learning Module 4: Overview of Private Wealth Management; Los 4(e) Evaluate a private client's risk tolerance