Why Risk Preference and Risk Capacity Need to Be Scored Separately

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Risk tolerance questionnaires have traditionally consisted of questions that produce one score centered around risk preference or attitude, which advisors then use to create portfolios or record the rationale for how they match clients to specific firm models.

This can often create misalignment as it may not expose the entire reality of an individual’s overall risk tolerance picture. As Michael Kitces stated in his article Adopting a Two-Dimensional Risk Tolerance Process, “…risk tolerance and risk capacity are two different dimensions of the client’s overall risk profile, and must be assessed and ‘scored’ separately…”

We break down the issues of using a one-score system, and the advantages of scoring them separately, below.

Variances in Feelings And Facts

One stumbling block of merging risk preference and capacity scores into one tolerance score is treating feelings and facts the same. A client’s attitudes about investing versus their actual ability to take on risk can be at opposite ends of the spectrum.

You can, for example, make the mistake of putting clients with low-risk preferences but high-risk capacities in portfolios far beyond their comfort levels. Likewise, you could have clients with low risk capacities and high preferences being stretched beyond their means.

When these scores are merged, there is no way to differentiate between your clients’ feelings about risk versus what they can actually withstand financially. When scored separately, you have a much better idea about their attitudes about risk versus their actual ability to take it on.

How Two Separate Scores Provide Parameters

Like two points on a line, two scores can provide parameters in which advisors can operate. When an advisor has a score for both risk preference and capacity, they now have a risk band and can eliminate portfolios and other investment options that don’t fall within that range. When there is only one score, it’s hard to know where the parameters begin and end, which makes it more difficult to know when a particular investment doesn’t meet the needs of a client.

Scoring separately also allows for quantification, at least through risk capacity. While risk tolerance is scored using arbitrary terms such as “conservative,” “moderate,” and “aggressive,” risk capacity is based on definitive, numerical answers. It can be calculated and, therefore, output a defined value. This number can then be assigned a place on a point system, which provides a fact-based reference point for the advisor and their clients.

Demonstrating Risk Capacity To Clients

It’s also easier to demonstrate your clients’ actual ability to take on risk when scored separately. Investing can be hard to understand and grasp for the average retail investor. Being able to demonstrate how their risk capacity can withstand more or less than their preference can help you manage their portfolios better and give them not just what they want, but what they need.

A client who has a conservative attitude about investing may decide to bear more risk when you can show them their financial ability to do so. Likewise, clients with more aggressive attitudes with diminished risk capacity may agree to the more conservative approach you’re recommending if you can show them their low risk capacity score.

These points become harder to demonstrate when the scores are merged.

Separate Scores Aid With Compliance

Finally, scoring preference and capacity separately can go a long way toward compliance, especially when the risk capacity score is based on the right questions. When you use a holistic questionnaire that calculates the score based on a broad band of relevant human capital questions, and not just investment time horizon, it becomes much easier to demonstrate that you acted in your clients’ best interests.

TIFIN Risk’s short questionnaire consists of targeted questions that collect the necessary data to score clients’ risk capacities and preferences based on the facts of their financial life. We assist advisory firms with compliance, prospecting, and client retention by calculating and comparing 3 risk scores- risk capacity, risk preference, and portfolio risk, all with a short, user-friendly questionnaire. 

Book a TIFIN Risk demo to learn more today. 

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