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Investors manage their love-hate relationship with risk

Investors have a love-hate relationship with risk. They love it when exposure to risk means higher gains in rising markets, and hate it when the flip side of risk shows up as bigger losses during corrections and bear markets.

Assessing investors' relationship to risk is more than a casual pastime for financial advisors. The Financial Industry Regulatory Authority suitability rule requires advisors to at least attempt to evaluate an investor's tolerance for risk before making recommendations.

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Guido Mieth | Getty Images

FINRA defines the concept as "a customer's willingness to risk losing some or all of the original investment in exchange for greater potential returns."

In practice, advisors tend to categorize investors in one of several buckets, such as aggressive, moderately aggressive, moderately conservative and conservative. Investors seen as aggressive and risk-tolerant typically have a higher percentage of equities, while the conservative, risk-averse will have more fixed-income assets.

Assessing risk well or poorly can powerfully affect returns, because a jittery investor can dump a wholly appropriate portfolio and sustain unnecessary losses, according to Cal Brown, a certified financial planner with Savant Capital Wealth Management.

"If you had the hypothetical perfect portfolio but the client wasn't in it when it went up in value, the client is not going to capture those returns," he said.

Most advisors use questionnaires to help assess client risk tolerance. Clients are asked to answer a series of questions aimed at determining their capacity and inclination to withstand losses.

For instance, a client may be asked how he or she would react if a portfolio fell 20 percent in a year. Another key question is how long it will be before the client starts making withdrawals.

Not everyone likes questionnaires that pose queries about feelings toward hypothetical investment losses.

"The worst thing to do when the market's already gone down is change your risk tolerance and go more conservative." -Byron Ellis, managing director at United Capital

"It's not a useful question to ask, because a lot of people don't know until it happens," said Paul Jacobs, a CFP and chief investment officer with Palisades Hudson Financial Group. "They don't see it as something that will ever happen." Jacobs does not use questionnaires, preferring to explore risk in client conversations.

Technology can also help. Planning software lets advisors generate scenarios with historical data to show clients how portfolios built with different risk tolerances would fare in up and down markets. Playing out dramatic drops like the 2008-2009 bear market is especially effective.

"The real-world information helps them make it real," said Byron Ellis, CFP and managing director at United Capital.

While some clients are blithe about risk, others are so risk-averse that it can be difficult or impossible to create a portfolio with returns adequate to achieve the client's financial goals. When this happens, advisors say, clients may need to be educated about risk's upside of risk and sometimes be encouraged to accept more.

Special situations can complicate or alter risk tolerance. One of the most common is when married investors have widely differing attitudes toward risk. Advisors generally suggest a compromise, then let the pair work it out. "We can't force their hand or tell them what the answer is," said Jacobs of Palisades Hudson Financial Group.

Advisors assess risk attitudes when taking on a new client and periodically after that. Later evaluations are rarely as formal as initial ones. Instead, advisors talk with the client during annual, semiannual or quarterly discussions to find out how the client is coping with market conditions and identify life changes that could change risk tolerance.

Job loss, death in the family, decisions to buy a second home and similar events signal time to reevaluate risk attitudes. The biggest, by far, is retirement, whether early or scheduled.

"During the accumulation phase, one can handle more volatility," said Larry Rosenthal, CFP and president of Rosenthal Wealth Management Group. "During the distribution phase, once you introduce withdrawals, you need to have less volatility."

One thing that universally makes advisors cringe is a client who switches risk tolerance during a bear market. "The worst thing to do when the market's already gone down is change your risk tolerance and go more conservative," Ellis said.

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However, advisors don't always accurately evaluate risk tolerance. "It's rare, but sometimes we have seen clients decide that stock investing is not for them and they just aren't comfortable seeing the value of their portfolio drop," said Jacobs.

In the end, evaluating risk tolerance remains as much art as science. Perhaps that's partly why some advisors are averse to risk when it comes to assessing their clients' ability to tolerate it.

According to Brown of Savant Capital Wealth Management, "It's better to dial down the risk so they stick with the plan than to go with the portfolio that's mathematically better but that they won't stick with."

— By Mark Henricks, special to CNBC.com