Financial Planning > Behavioral Finance

How to Determine Clients’ True Risk Tolerance

Your article was successfully shared with the contacts you provided.

In 2009, when Mark Friedenthal went scouting around the marketplace for the right kind of financial planning software for his new firm, Friedenthal Financial, he just could not find a product that he deemed good enough to properly assess his clients’ risk tolerance levels.

Most advisors, he learned, appeared to be using a simple, one-dimensional method — in essence, a personality test — to gauge how much risk their clients could stomach. However, risk tolerance is a much more complex and deeply nuanced concept, Friedenthal knew. It is a reflection of individual personalities, and changes over time, with age and with the vagaries of the financial markets. In his view, it is also dependent on something very concrete: cash flow.

Friedenthal, a mathematician by background, saw no other way forward than to build his own proprietary model for assessing risk tolerance in a way that not only measures a client’s willingness to take on risk, but also their ability to take on that risk, based on their cash flows.

What began as a simple, in-house excel spreadsheet grew over the years into Tolerisk, a robust tool for financial risk assessment grounded in science and mathematics that is used by close to 80 small financial advisory firms.

“Tolerisk gives advisors what they need to properly answer client questions like ‘What should I do now?’ and ‘How much risk should I take on?’” Friedenthal said.

How It Works

The model is built on the premise that it is impossible to properly assess a client’s risk tolerance without analyzing both their willingness and their ability to take on risk, he said. The latter is a function of the anticipated cash flows in and out of their portfolios over time. The product generates a range of numerical stock and bond benchmarks that are clear, measurable and actionable to both advisor and client. By bringing both willingness and ability together, Tolerisk presents a full picture to the advisor of their clients’ risk tolerance, Friedenthal said.

Tolerisk also alerts financial advisors to the most important variables driving a particular client’s risk tolerance – something that’s important for clients to be aware of, too, so they can better understand the factors that are shaping their behavior and are guiding them in their risk tolerance behavior.

The model incorporates mortality probabilities that allow advisors to compute the likelihood that their clients will outlive their money.

“The most common question clients ask their advisor right before retirement is ‘Am I going to run out of money?’ but they phrase it as though it were a yes/no, binary kind of question, as though advisors can give them one answer,” Friedenthal said. “Really, there are three moving parts that make up the answer: ‘We don’t know what your portfolio will be [at retirement], what your expenses will be and how long you will live.’ Tolerisk is built to give advisors what they need to answer all those questions.”

Tolerisk is the cornerstone of Friedenthal Financial’s approach. Clients of the firm have said they greatly appreciate the model and how it enables them to see the key drivers of risk tolerance as they evolve over time, and the way in which it estimates their probability of financial longevity and expected asset balances in the future, Friedenthal said.

His company also relies on an intuitive, web-based portal that provides clients 24/7 access to their individual portfolio and dynamic performance reporting. The portal also functions as a document vault and a secure way for interactive communication between advisors and their clients, allowing them to send and receive documents via a secure platform.

Friedenthal hopes to keep strengthening Tolerisk and making it even more robust as time goes on and the fiduciary demands on advisors become more onerous. He relies heavily on stakeholder feedback and on advisor insight to guide him. Recently, based on requests from advisors, the Tolerisk team developed a mini version of the product that can be used to take a quick read of prospective clients’ willingness and ability to take on risk.

“Although it only takes five minutes and very little effort to review, the tool is still two-dimensional, which makes it analytically more robust than other tools out there,” Friedenthal said.

— Read Riskalyze Rolls Out Automated Platform, New Products: Tech Update  on ThinkAdvisor. 



More on this topic