Sunday, June 30, 2013

Evaluation of Client Risk Profile – Part II /II (Risk Tolerance)

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


Risk Tolerance
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.
Compared to the evaluation of risk ability, where basically current holdings need to be analyzed and future funds in- and outflows need to be evaluated, finding out on risk tolerance is significantly more difficult. Below three approaches to evaluate clients risk tolerance:
Personal Unstructured Conversation with the Client Investment advisor explains the client the potential products to invest in. He explains how they work and what risk they involve and how much money the client could win in the best or lose in the worst case. He lets the client talk and asks ad-hoc questions in order to find out more on risk tolerance. This approach requires a very experienced investment advisor. It was a common approach 10 to 20 years ago.
Risk Profile Questionnaire
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”
Back Tracking
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.

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