In order to evaluate which risk to take, when investing his funds a client needs to be aware of his risk ability and of his risk tolerance. It’s a very important part of an investment advisors job to help the client on this subject
The risk tolerance defines how a client deals emotionally with investment risks. Although a client could easily afford to lose 50 % of his fortune due to high regular income, it is possible that dropping stock markets, which cause an unrealized loss of 10% on client’s investments could make him freak out. In the worst case the client wants to sell his position and realize the loss. Although the advice was good and long-term would have generated a high profit it is a fail. The client has realized the loss and probably will never ever touch these investments again. Therefore recognizing client’s risk tolerance is key.
This is a structured standardized approach, which allows to ensure a stable standard when evaluating client’s risk tolerance. The client has to fill in a questionnaire on paper or even better, electronically. The questionnaire usually consists of 30 to 40 questions. These questions cover areas such as: Current situation, familiarity with investment matters and time horizon. An important part are the examples such as “Your investment fell by more than 10% over a short period. What would you do? Sell all, sell a portion, hold or invest more funds”
In this case based on conversation with the client the investment advisor is proposing an asset allocation and an selection of assets. Then the system calculates for exactly this proposal, what would have happened based on the market developments of the past 10 years. What was the maximal drop in one week/one month? What was the longest underwater period (period during which the investment is trading for less than the purchase price) etc. Personally I prefer this approach. The challenge is the huge number of data needed and therefore the required IT capacity.