(Bloomberg Business) — Financial advisors say clients often overestimate their tolerance for risk. But data suggest it’s really financial advisors who become more nervous than they expected when markets become volatile.
Advisors often underestimate their own stomach for risk significantly, by as much as 20 points (on a scale of 1 to 100), according to FinaMetrica, a firm that runs psychometric risk tolerance tests. The danger is that advisors can inadvertently push their perceived higher tolerance for risk onto clients when designing a portfolio, according to Tyler Nunnally, FinaMetrica’s U.S. strategist. The 800,000-plus tests FinaMetrica has analyzed show that most clients of advisors just slightly overestimate their comfort with investment risk.
There is something to advisors’ belief that their client’s risk tolerance seems to change with the markets. But Nunally argues that it’s not any change in actual risk tolerance, which he says is a stable trait. “There’s a perception that the market is less risky when it’s up and more risky when it’s down,” he says.
Whether risk tolerance is a fixed trait or a fluctuating state of mind, recent volatility in markets around the world makes now a good time to check your comfort with risk. While a wealth of free risk questionnaires are available, many are a waste of time, says advisor Curt Weil: “What was comfortable in December of 1999 was horrific in April of 2000.”
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What Weil does to provide an objective reality check for clients is to simulate a decline of 50 percent in a portfolio and show a client how that would affect her ability to meet her life goals. After speaking with clients about how volatility is normal and should be expected, advisor Kevin Couper takes a similar approach to Weil’s, using a “worst-case” scenario that relives 2008 with a client’s current assets.