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How to Set Investors Up for Success With Risk Profiles

Key Takeaways

  • If your clients’ portfolios aren’t aligned with their true risk tolerance, market downturns can cause hasty, knee-jerk reactions that lock in losses at the worst possible time.
  • Risk tolerance is a psychological trait that, when measured correctly, typically doesn’t change over time and can inform a long-term financial plan.
  • Long-term portfolios built on a reliable risk tolerance profile can help you set better expectations with clients and guide them to better outcomes.

Read Time: 5 Minutes

Recession rumblings. Inflation fears. Interest rate hikes. In the palms of their hands, investors have access to market information like never before.

Closely monitoring market moves can lead to worried calls about what to do next. How can financial advisors navigate this new, noisy environment?

When you’re giving advice, you want investors to stay focused on their long-term goals, not economic uncertainty during the years in between. We can't ignore what's happening in the market now—but we also can't ignore what clients need to do to achieve their ultimate investment objectives.

With proven risk profiling, you can set better expectations about client portfolios for more productive conversations.

Table of Contents

What Is a Risk Profile?

A risk profile is an assessment of an individual's willingness and ability to take on risk in their investment portfolio. It takes into account factors such as:

  • Risk tolerance, a psychological trait that reflects a client’s willingness to take risks to meet their financial goals. Risk tolerance may shift slightly after life events or as clients age, but when measured correctly, it remains remarkably stable.
  • Time horizon.
  • Prior investing experience
  • Investment knowledge.
  • Composure, or how badly you feel in the short run when markets lose money. Spoiler alert: Most folks don’t like to lose money. But that doesn’t mean they’re not willing to suffer short-term losses on the road to long-term value creation.
  • Capacity for loss.

Here's what some advisors get wrong.

However, many advisory firms use questionnaires with short-term outlooks or homegrown versions that don’t always lead to better client outcomes. In today’s environment of growing regulations, firms must understand how their risk profilers work.

What evidence backs up those risk assessments?

The stakes are high for business results, too. One Spectrem study found that on average, over 20% of clients leave their advisor in the first year. The top three reasons:

1. Lack of good communication and service.

2. Lack of understanding of the client’s overall financial goals.

3. Poor understanding of a client’s willingness to take risks.

Connecting the client to an appropriate portfolio has its own pitfalls. Often, risk profiling will drop investors into one of five or seven buckets associated with a target asset allocation.

For example, picture a client who’s a moderate risk-taker. She thinks of risk as uncertainty but feels confident about her investing decisions. Based on her risk profile, you might want to recommend a 60/40 stock/bond portfolio.

But what goes into that 60% stock allocation? Sub-asset classes can lead to meaningfully different levels of risk. Does your investor have exposure to international or emerging markets? What bonds are in her portfolio—corporate, high-yield, or government bonds?

Poor measuring sticks can also cause portfolios to get recategorized based on short-term market movements.

Any investment product with some amount of stocks will experience some volatility, but just because a portfolio has a down period doesn’t necessarily mean it’s suddenly unsuitable for your client. Yet many portfolio risk metrics make the mistake of focusing on short-term volatility.

A well-diversified moderate portfolio’s bout of poor performance doesn’t mean it’s unsuitable for a client who was properly profiled as a moderate investor. Instead of churning investors out of such a portfolio, most advisors want to keep their clients invested and guide them through the downturn. And the profiling tools and risk metrics they use should help them do just that.

There’s a more scientific way to think about risk. Here’s how Morningstar’s risk profile assessment works.

How Much Risk Can Investors Handle?

The Morningstar Risk Profiler measures risk tolerance, a psychological trait that doesn’t change over time for most clients.

Morningstar’s psychometric questionnaire [PDF] for risk profiling has been taken more than two million times by investors around the globe. Every few years, advisors will assess their clients again using the same test. Here’s what they found.

Risk profiling over time graph.

Our Risk Profiler data show that while stock markets roar up and down over time, risk tolerance varies little. In our system, if a client has a High risk tolerance when tested in a bull market, they’re highly likely to have the same outcome when tested in a recession.

The questionnaire has held up under independent scrutiny. Academics have had access to anonymized test data for almost two decades, making it the most researched method available [PDF].

Does Your Investment Proposal Match Your Client's Risk Profile?

As an advisor, you need to accurately measure the level of risk your client wants or needs to take. You also need to understand how much risk they’re currently taking and how it differs from the amount of risk they are comfortable with.

The Morningstar Portfolio Risk Score uses a similar long-term approach to assess investments.

Morningstar’s system uses a family of long-term indexes as benchmarks to help measure and characterize the absolute risk of a client’s portfolio.

Each broadly diversified index is based on target allocation products in the market. The benchmarks represent the market's collective wisdom about the definition and allocation of a conservative to aggressive portfolio.

The Portfolio Risk Score can assess an overall mix of investments. It can also score underlying investments—funds, ETFs, managed accounts, model portfolios, and equities—by comparing the current and long-term volatility profile of each to a relevant index.

Tie Person to Portfolio With the Risk Comfort Range

Morningstar’s Risk Profiler helps you measure how much risk a client is comfortable taking.

Our Portfolio Risk Score helps you measure how much risk they’re currently taking.

And a third piece, Morningstar’s Risk Comfort Range, helps you tie the two together to personalize investment recommendations.

The Risk Comfort Range is based on the Risk Profiler output and connect a client’s risk tolerance to a specific and personalized Portfolio Risk Score range that is appropriate for them.

The Risk Comfort Range is further adjusted based on the client’s time horizon for each goal or investment objective. No matter how risk tolerant a client may be, the appropriate amount of risk needed for retirement 30 years in the future will differ from the risk they should take for a home purchase in two years’ time.

A range, versus one of five static profiles, gives you flexibility in your investment proposals. If you believe a client needs to take more risk to reach a more ambitious financial goal, you can choose investments at the higher end of a client’s Risk Comfort Range. Or you can do the opposite for clients who worry a lot about short-term losses.

You can make thoughtful decisions about proposals that fall slightly above or below the recommended comfort range to easily personalize your advice.

You'll get real-time feedback as you make different investments and allocations while creating your proposed portfolio in our software. You’ll be able to show clients the riskiness of specific investments and explain how their portfolio fits their goals.

The Risk Comfort Range can help investors visualize their trade-offs, lean into their plan, and feel more confident in your recommendations.

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Balancing Risk and Reward in Investment Portfolios

While investing for long-term goals, investors must face down perceived risk and market volatility in the short term. But good advisors know they must stay focused on the long term for clients to reach their financial objectives.

With the right tools, you can guide your clients to see the bigger picture. With better profiles, and better portfolio analytics, you can set your clients up with the right portfolios, set the right expectations, head off panic in eventual market downturns, and ultimately get them to their goals.

Schedule a demo of Advisor Workstation and see risk profiling in action.