The Art Of Assessing Risk Tolerance

Measuring risk of an investment is mathematical.  Measuring the risk tolerance of a human is art and experience.

The biggest challenge of selling investment advice is the determination of a client’s risk tolerance.  Financial advisors know, or should know, how to analyze an investment to determine the risk of loss; and then match that investment with the risk tolerance of the client. 

So how does the financial industry equip advisors to measure risk tolerance of humans?  Questionnaires.  Risk tolerance questionnaires.

But not all questionnaires are the same.  Some have a few questions; some have many.  Some have very simple scoring methods, while some scoring methods are completely unknown to the advisors.  I have often wondered why these questionnaires are so different.  Is this one better than that one?  How many questions should be asked?   What kind of questions should be asked?  What does the score actually mean?

No perfect questionnaire can anticipate human response to known or unknown events.   Determining risk tolerance requires the advisor to observe and discuss the client’s reaction to changes in their investments.  It requires the client to communicate their thoughts and concerns to their advisor.   Therefore, understanding the risk tolerance of a client requires time, events and communication – something very different from a questionnaire.

Everyone’s tolerance for risk is different.  People react to the same event in different ways.  

Just think about the worst airline flight you ever had, one with lots of turbulence and wind.  Did you ever look around at the other passengers and their reactions?  Some of them were fearful, possibly screaming; while other were calm.  Every one of them reacted in their own way to the unknown and unexpected.

Excellent wealth management is about talking your client through the turbulence.