Advisers typically employ risk questionnaires as one input for the advice they provide to their clients. Such questionnaires are a common, albeit imperfect, tool.

This is not intended to be a critique of questionnaires, but rather a reflection of the all-too- fickle nature of an investors’ tolerance for risk, and their emotional dispositions in the face of volatility and perceived loss. What can an adviser do to help clients better understand risk and improve their odds for investment success?

For both clients and those professionals who advise them, a risk tolerance that ebbs and flows with the market tide is less than ideal. After all, the asset allocation is based on the client’s long-term objectives and constraints, making “flip-flopping” unwise. (Time horizon is arguably the most significant constraint, but risk tolerance, among other considerations, also plays an important role.)

Quote
Headlines in the markets should not be sufficient reason to change risk tolerance or asset allocation; changes in the headlines of a client’s life might be: the birth of a child, the loss of a job or imminent retirement.

However, there are some things our industry can do better to prompt a more accurate “risk answer” during the discovery portion of the planning process and prior to constructing a client’s portfolio. For example, instead of framing the losses in percentage terms, consider using dollar terms. Psychologically, it seems to make more of an impact to the investor and, hopefully, will prompt a more honest and accurate baseline risk assessment. A loss in percentage terms seems both hypothetical and intangible. But a loss in dollar terms, say -$250,000 instead of -25%, seems real and feels real.

Isn’t it easier for the investor to envision all of the things that the $250,000 might have provided? College tuition. Years of retirement spending. That vacation home in the mountains. Simply put, a better way to convey the price of risk is to use a dollar sign, instead of a percentage sign.

People have been alarmed by the return of volatility, rather than seeing it for what it is: More normal than not, writes Vanguard's Donald Bennyhoff.

However, an investor’s risk tolerance is not carved in stone. Nor should it be. But how can you differentiate a client whose risk tolerance has genuinely changed and requires a modification of the asset allocation from one where the change is fleeting?

While reacting to headlines or circumstances in the markets should not be sufficient reason to change a client’s risk tolerance or asset allocation, changes in the headlines of his or her life might be: the birth of a child, the loss of a job, a lottery or inheritance windfall, or imminent retirement.

These are perfectly valid reasons for change, underscoring an important realization for those providing advice. In short, changes that may reasonably affect the asset allocation strategy may occur, but they should be very infrequent events over an investor’s lifetime and unrelated to exogenous events or headlines.

In fact, confirming a client’s risk tolerance is frequently an ongoing, iterative process. That’s actually good news – for both the client and the advisor. In this way, an advisor can help clients contend with the events of today and the uncertainty of tomorrow. In fact, the behavioral coaching that an advisor can provide clients is, according to our research, the single largest source of potential value in an advisory relationship. As each event unfolds – either good or bad – both questions and emotions arise, as do opportunities to help clients, build relationships, and foster loyalty.

When we think about trying to gauge a client’s risk tolerance, we should expect it to change over time. Risk has many definitions; while “loss” is one, “uncertainty” is another. While we have many risk management tools to help us contend with risk of loss, such as asset allocation and diversification, the best tool for dealing with uncertainty isn’t a portfolio strategy, it’s a people strategy.

For instance, when events occur – Fukushima, Brexit, the US election results – touch base with your clients. A “hey, how are you doing?” call has nothing to do with their portfolio; it’s all about the person. And, while these events may understandably increase a client’s apprehension, these episodic concerns should typically be distinguished from the more relevant changes in our clients’ lives.

If you want to help clients manage their attitude toward risk, it’s best to understand that it isn’t likely to stay constant. While risk of loss may be how investors define their risk tolerance in the questionnaire at the beginning of the relationship, it’s likely that uncertainty will reign thereafter. If so, then an advisor’s behavioral coaching and relationship management skills, rather than his or her portfolio management skills, will take precedence in taming the fickle nature of risk tolerance.