Risk Profiling – the crucial part for a successful client/adviser relationship
Risk profiling is the process of evaluating the risk attitude of a person. A risk profile identifies:
1. The acceptable level of risk an individual is prepared to accept.
2. The risks and requirements already faced by an individual. The risk profile may include unique circumstances, legal and regulatory factors, tax concerns, time horizon and liquidity needs.
When preparing a risk profile one has to distinguish between willingness and ability to take risk. Both determine the level of acceptable risk, whereas ability and willingness can differ significantly.
A person’s ability to take risk is mostly determined by external factors such as time constraints, career stability and current wealth.
A person’s willingness to take risk is mostly determined by internal factors such as personality and behavioral tendencies.
The combination of an investor’s willingness and ability to take risk will determine their risk tolerance.
Either the willingness or ability to take risk could be more important to determine an investor’s risk tolerance. For example, an investor who is willing to take more risk (willingness), but close to retirement (ability) will have a reduced risk tolerance. Or an investor could have a long time horizon (ability), but is disturbed by any negative fluctuations in investment value (willingness) and also has a reduced risk tolerance. An investor’s risk profile is the starting point for a deciding an investment strategy.
After completion of risk profiling, the risk attitude of a client can be determined. In general there are three different risk categories:
1. Risk-averse investors do not like uncertainty and volatility. Such investors are willing to settle for a lower return on their investments . A cautious approach should be applied.
2. Risk-neutral investors are indifferent to risk. Additional risk and volatility should be accompanied with a extra return. A balanced approach should be applied.
3. Risk-loving investors are willing to take more risks while investing in order to earn higher returns. A growth approach should be applied.
There are many factors for determining risk tolerance and an investor’s risk tolerance can change over time. It is important to regularly review investments to ensure they are still within an investor’s risk tolerance, and to regularly review an investor’s risk tolerance to ensure it has not changed.
Shoreline is able to help clients determine their risk tolerance and advise on investments which will fit. Ongoing service and advice will ensure the investment risk and client risk tolerance are still suitably matched.