What Is Risk Tolerance in Financial Planning?

Whether you’re reassuring current clients they’re on the right track or looking to attract new prospects to your firm, quantifying your value as an advisor is important. But did you know that leveraging powerful platforms like Nitrogen can help you transform something as unique as a client’s risk tolerance into a long-term growth and retention strategy?

Let’s take a look at how risk tolerance has evolved over the years to become a powerful metric for advisors, especially when it comes to achieving their firms’ growth goals. 

Related: Click here to read “Nitrogen 101: What is the Risk Number?”

Risk Tolerance in Financial Planning: 6 FAQs

1. What Is Risk Tolerance in Financial Planning?

According to the Securities and Exchange Commission (SEC), the definition of risk tolerance is “an investor’s ability and willingness to lose some or all of an investment in exchange for greater potential returns.”

Traditionally, risk tolerance has been demonstrated using a sliding scale from “conservative” to “aggressive.” The former indicates an investor is able to take on the least amount of risk, and therefore expects to receive the least amount of return. The latter is the opposite – an investor takes on the most amount of risk, with the potential for the greatest amount of return.

Of course, most individuals lie somewhere between those two extremes, and it falls to you as their advisor to quantify each client’s risk tolerance and then build a strategy that aligns with it.

2. How Can Financial Advisors Assess a Client’s Risk Tolerance?

Advisors can use a risk tolerance questionnaire or survey, like the Next Gen Risk Assessment, to help determine and quantify their clients’ risk tolerance.  

Before data-driven questionnaires became the new industry standard, advisors may have used different methods to assess a client’s tolerance for risk (though they presented some difficulties):

• Assessing market sentiment: Basing a client’s risk tolerance solely on the market’s movements is not only too narrowly focused, but it sets the advisor up to chase a forever-moving target (since market sentiment is constantly changing).
• Stereotyping investors: Sticking investors into broad categories like “aggressive” or “conservative” based solely on age creates overgeneralizations and often does not accurately describe an individual client’s true tolerance.
• Using hypotheticals: Since they aren’t tied to real, relevant dollar amounts, hypothetical scenarios may be good for demonstrating certain strategies but ultimately don’t get to the heart of an individual investor’s true risk tolerance.

While risk tolerance questionnaires have been around for a while, some legacy versions lacked appeal and ease of use. As a result, they often left clients feeling overwhelmed and confused – not to mention, they often created unrealistic expectations.

Today’s risk assessment tools are designed with two things in mind: delivering high value to a client or prospect and generating qualified leads for advisors. 

The Next Gen Risk Assessment, for example, uses a Nobel Prize-winning scientific framework for generating an individual’s unique Risk Number® on a scale from 1 to 99. This number provides an objective, quantitative measurement of an investor’s true risk tolerance – no generalizations, stereotyping, or unrealistic expectations.

3. What Are the Best Practices for Discussing Risk Tolerance with Clients?

When you’re able to kick off a new client relationship by determining their tolerance for risk, you’re demonstrating a few important things right off the bat.

First, you’re telling your client that you’re committed to providing tailored advice that addresses their unique needs based on their risk tolerance and long-term goals.

And second, you’re assuring them that you’re acting in their best interest – all while putting them in the driver’s seat of their financial life.

But what can you do to make conversations around risk a little less stressful for your clients? While every advisory firm operates differently, it may be helpful to start by explaining what risk tolerance means, why it’s important to understand, and what factors influence it. Sometimes, simply “demystifying” investing terms can help ease investor anxiety.

We’ve seen some advisors find great success in transitioning away from the corporate office feel and conducting risk questionnaires in a more relaxed environment—like the team at CornerCap does. By guiding clients through the questionnaire in a more relaxed environment, advisors have found they can get investors to be more transparent and open about their needs and goals.

4. Why Is Understanding Risk Tolerance Important for Investment Strategies?

Knowing a client’s risk tolerance enables an advisor to compare the current risk in the client’s portfolio to the risk they want and need. In short, it enables the advisor to determine the appropriate asset allocation within each client’s portfolio.

It’s also worth noting the potentially long-term consequences of delivering investment advice and strategies that are not aligned with a client’s risk tolerance. Not only can this lead to client dissatisfaction (and the potential loss of a client or future referrals), but it can expose clients to unwarranted financial loss as well. In the most extreme cases, regulators may find that you did not act in your client’s best interest and you could be subject to further investigation or fines.

Working with a client’s objectively defined risk tolerance can help advisors avoid misaligned strategies from the start of the relationship.

5. How Can Risk Tolerance Questionnaires Help in Client Engagement?

Risk tolerance is critical to setting expectations. Advisors can use a client’s quantified risk tolerance number to illustrate what a normal, diversified portfolio should look like, especially as the market jumps up and down. 

Demonstrating this to clients can help them remain invested long-term despite varying market conditions while trusting you to manage their portfolio appropriately. 

6. How Can Leveraging Risk Tolerance Help Advisors Grow?

Confusion and uncertainty don’t lend themselves to a successful growth strategy – which is why advisors who plan to grow their firms must find ways to create clarity and transparency with clients and prospects.

Being able to quantify risk tolerance can help you reframe your client and prospect expectations while giving you the tools and data you need to deliver ultra-personalized strategies and portfolio analytics.

Ultimately, the ability to quickly quantify, understand, and communicate a client or prospect’s risk tolerance number gives you the power to deliver more value, showcase your difference, and demonstrate your fiduciary duty. 

Discover What Nitrogen Can Do For You

Not all risk tolerance questionnaires are created equal – especially when it comes to leveraging results to drive growth. Schedule a free demo of Nitrogen today to learn more about how our Next Gen Risk Assessment can power your firm’s growth goals.