The preferred outcome of the advisory process is that the investment recommended suits the investor’s goals and also takes into account the investor’s risk capacity and risk tolerance.
This process is a blend of art and science. The science lies in the tools the adviser uses. The art lies in the adviser’s ability to use the tools effectively, to work collaboratively with clients to understand their needs, to assist in resolving mismatches by explaining alternatives, and to guide the decision-making process.
When assessing risk acquired, the projection capabilities of good planning software are used to determine the return required to achieve goals. There will be a level of risk associated with that return – and this is the risk required. The portfolio selection is based on this.
The science lies in the financial planning software. The art lies in explaining the relevant issues to the client, eliciting the right information, resolving conflicts, and determining expected returns for portfolios and the capital market assumptions upon which they are based.
Risk capacity is the extent to which an individual’s financial plan can withstand the impact of unexpected events.
For a goal as important as income in retirement, for instance, a 50 per cent chance of success is unlikely to be acceptable, which means that trade-offs will be required. In a comprehensive scenario, risk capacity is measured by the excess over 50 per cent of the likelihood of achieving goals.
Clearly, unexpected negative outcomes might derail the client’s plan and this means the plan must be stress-tested. All forms of stress testing are driven by assumptions: capital market assumptions for investment returns, life expectancy for longevity and so on. If we do a poor job on these assumptions, any stress test will be compromised.
With risk capacity, the science is in the calculations, the art lies in explaining the concept to the client.
Risk tolerance is how an individual feels about taking risk. Where is their emotional balance between a favourable outcome versus risking an unfavourable outcome?
Psychometrics is the scientific discipline used to assess characteristics such as risk tolerance. With risk tolerance, the science is in the questionnaire and scoring algorithms.
The art is in the discussion between adviser and client – explaining the risk tolerance report, resolving inconsistencies, arriving at a final assessment, obtaining acceptance of the assessment.
Risk tolerance is more likely to be consistent between planning sessions than risk required and risk capacity. That consistency makes it a useful foundation for both planning and investment decisions.
Paul Resnik is a director at FinaMetrica