Investopedia (2013) defines Risk Tolerance as, “an important component in investing. An individual should have a realistic understanding of his or her ability and willingness to stomach large swings in the value of his or her investments. Investors who take on too much risk many panic and sell at the wrong time”. (Risk Tolerance section, para. 12). When helping clients create investment portfolios, it is important to be aware of their risk tolerance. There is no absolute science to determining a client’s risk tolerance; rather, there are many tests available that can help produce an idea that gauges a client’s interests and comfort level with respect to risk tolerance. Assessing your clients’ risk tolerance is critical to being able to help them construct an investment strategy and portfolio that meets their financial needs. There are many complexities that can influence and cause you to inaccurately gauge your clients’ true risk tolerance, both cognitive and emotional. Misinterpreting these complexities or failing to take them into consideration can affect your ability to help the investor reach his or her goals. In today’s financial marketplace, a well-maintained portfolio is vital to your clients’ success. As a financial planner, you need to know how to determine an asset allocation that best conforms to your clients’ investment goals. Your client’s portfolio should meet their future needs for capital and give them peace of mind. As the financial planner, you can construct portfolios aligned to your client’s goals with your investment strategies by following a systematic approach. There is a process for assessing your client’s tolerance for investment risk and there are several key factors that one must evaluate in order to confirm their understanding of their client’s risk level.
Ascertaining the client’s individual financial situation and investment goals is the first task in constructing a portfolio. Important items to consider are age, experience, net worth, risk capital and the actual investment or trade being considered. According to William, N., McHugh, J., and McHugh, S. (2005), “a young person can afford more high-risk options (such as stocks) than a person nearing retirement. Often young investors are looking for significant growth in the value of their investments over time… To an elderly investor, additional income is probably more important than potential growth” (p. 624). The younger clients also have a longer time horizon in which to grow assets. The second factor is, what is the client’s time horizon for the money in the different types of investments? The time horizon of clients will have an impact on how much risk they are willing to take. The third factor would be the client’s investment goals. Depending on the client’s goals, it will make a big difference on where they want to invest their assets. If their goal is safety of principle, they should be willing to take on very little risk. If the client’s goal is aggressive growth, they should be willing to take on much more risk. The fourth factor is personal earnings and the client’s emergency funds. The client’s income is an important driver of their investment program. If they feel their income will decline in the future, the clients will likely be much less willing to tolerate risk than if they think their income will increase dramatically. The more money the clients earn and have, the more money that can be used as an emergency fund, and the more they are able to take on additional risk. The fifth factor is the client’s investment risk. Which investment would they be more comfortable making? Stocks have the greatest risk but offer the greatest potential for growth among the three major asset categories. Bonds are generally less volatile than stocks but offer more modest returns. There are certain categories of bonds that offer high