Do clients really understand their risk tolerance?
"Risk tolerance is an incredibly difficult thing to define, articulate and then understand for any individual," said Kevin M. Reardon, certified financial planner and president of Shakespeare Wealth Management. "Trying to sync a client's understanding with an advisor's understanding is even more difficult."
Reardon's company requires every client to complete an educational workshop that defines risk and how the firm manages it. Clients must also fill out a new risk-tolerance questionnaire every three years.
"I wish an auditor and an arbitrator could watch clients struggle through the five questions on the questionnaire," Reardon said. "These are longstanding clients who I thought had a good understanding of the capital markets, our investment philosophy and our portfolio management process."
There is no silver bullet in helping clients understand risk, he said, although walking clients through "what if" scenarios of a market decline helps.
Reardon suggests asking clients questions such as: What if your $1 million account drops to $750,000? Can you handle it? Will you be calling us? Do you understand we won't sell equities at that point in time but will actually buy more? Do you? Please sign here so I can remind you when it happens.
The bottom line, he said, is that when the markets drop significantly, there will always be clients who are surprised by downside volatility and motivated by fear.
"Risk tolerance in the context of a questionnaire is very different than risk tolerance when one's money is actually on the line," said Robert Wander, certified financial planner and owner of Wander Financial Services. "It is often a rear-view mirror indicator [because] when markets are rising and less volatile, risk tolerance rises and vice versa when conditions change."
Wander said it is the advisor's job to ultimately choose an approach that he or she feels is right for the client, even if this does not fully correspond with the client's stated risk tolerance.
"It can be a tricky balancing act to choose what one feels is in a client's best interest but not diverge too much from their comfort level, which can lead to emotional and counter-productive responses on their part," Wander said.
Some commonly used risk-assessment measurements include:
Some question the value of assessments altogether. "I think risk-tolerance assessments are useless," said CFP Dana Anspach, CEO of Sensible Money. "Nobody really knows how to answer. Most of them are a legal requirement, designed to protect the company, not the consumer."
Anspach said there are three aspects of risk tolerance:
Most risk-tolerance assessments only measure the first aspect, and they don't do it well, she said.
"Portfolios are best built on items 2 and 3," Anspach said. "If you have a 20-year time frame, what your portfolio does this year is irrelevant.
"If you are retiring next year, it is quite relevant," she said.
Anspach believes it is more important to educate clients than assess them. She takes her clients through a series of presentations on historical rates of return and volatility, showing a range of possible outcomes if clients followed their same strategies during different eras of time.
For his part, Zach Abrams, CFP and manager of wealth management and portfolio analysis for Capital Advisors, believes risk assessments are flawed.
"Clients don't understand what standard deviation and volatility mean," Abrams said. "There will be times they will be outside of what they might expect the downside to be."
He believes that showing clients standard deviations of volatility only tells part of the story because market returns are not normally distributed. Furthermore, many portfolio risk/return profiles only go back to the late 1970s — a small sample size that does not include 1929.
"Given how positively skewed the market returns have been — the greatest stock and bond market runs since the '80s — the models will probably overstate returns and understate volatility," Abrams said.
Because people don't know how they'll react in a down market, they should be asked about their risk tolerance after they have a complete understanding of their personal financial situation.
"They need to have a combined understanding of standard deviation and historical maximum loss," Abrams said. "We need to make sure they won't sell at the bottom."
— By Deborah Nason, special to CNBC.com