What is a client willing to endure to achieve their goals?

Experts from Morningstar explain how understanding an investor's appetite for risk is key to ensuring a long-term relationship

What is a client willing to endure to achieve their goals?

This article is sponsored by Morningstar.

No one likes unpleasant surprises, and this is particularly true for investors.

And yet the markets are full of surprises. Even the best investment portfolios will lose money at an average rate of about one month out of three. Then there are those gut-punching years like 2022 and 2008.

This adds up to quite a challenge for advisors, who need to ensure their clients are fully prepared for the short-term volatility of the markets. A failure to do so is one of the reasons a client will sever a relationship and find another advisor.

Fortunately, there is a solution. While no one can control the market, an advisor can control the degree to which their clients are surprised by the market.

The goal, explains Ryan Murphy, an expert in investor behaviour at Morningstar, is to help clients understand that the path to longer term rewards is occasionally paved with short-term risks.

“This is an opportunity for an advisor to calibrate their client’s expectations around a good investment portfolio,” Murphy says. “When the expectations are met, when there are no surprises – you now have a solid foundation for trust where clients will stay the course and ultimately reap the benefits of investing over the long term.”

Murphy is the Global Head of Behavioral Insights at Morningstar. Together with colleague Nicki Potts, Morningstar’s Director of Financial Profiling & Planning - Behavioral Sciences, they recently sat down for an interview with Wealth Professional to discuss the importance of clarifying risk within the advisor-client relationship.

Assessing a client’s appetite for risk

People can be just as unpredictable as the markets they’re investing in. Different clients are going to have different approaches to risk. They’re going to have different reactions to swings in the market.

Potts says one way to determine a client’s tolerance for risk is through a series of questions that are designed to trigger a range of aversions and preferences.

This questionnaire is an important tool, she says, but it’s really just the beginning of what needs to be a rigorous and ongoing assessment of a client’s approach to risk.

“A lot of people think this type of assessment tool is the be-all and end-all of risk profiling, but it’s not. It’s just the beginning of an ongoing conversation with your client that will keep exploring trade-offs and deepening understanding.”

Key to furthering this understanding is the need to break risk down into its various components, two of which are risk tolerance and capacity.

Risk tolerance, for example, is how emotionally comfortable an investor is with potential losses. Risk capacity on the other hand refers to how much risk a client can afford to take in the long run.

Additional factors to consider regarding risk are an individual’s investing experience, knowledge, and preferences.

It all adds up to a fascinating exploration of the nature of risk, and it reveals how important it is for advisors to see their clients as individuals. The differences among individuals are so unique that they drown out any differences that emerge between cultures and countries.

“The differences across countries are very small,” she says. “The tolerance for risk around the world is pretty similar, and that allows us to use our risk assessment tools globally. It doesn't need to be tweaked for country differences.”

Potts also warned against falling back on other stereotypes that involve age or gender. While men are generally more tolerant of risk than women, for example, the difference isn’t big enough for an advisor to make broad assumptions about their clients.

Understanding the specific risk profiles of their individual clients can benefit advisors in another way as well. When an advisor’s risk assessment reveals new information about clients that even the clients themselves didn’t know, it creates a starting point for more meaningful conversations.

It’s a process of self-discovery that enriches the client-advisor relationship beyond the usual parameters around investing money.

From clarifying risk to defining goals

Ensuring that a client understands risks is important. It enhances their knowledge of both investing and themselves, while strengthening the relationship they have with their advisor.

But the most important objective of a comprehensive risk assessment is to create – and ultimately achieve – a clearly defined investment goal. Once a client is able to see short-term volatility within a bigger picture of a long-term goal, they are more likely to avoid impulsive decisions and stick with a well-founded plan.

“Investing is to some degree an unnatural process,” Murphy says. “It requires people to be patient and embrace uncertainty, but our brains aren't wired for doing these things well.”

This presents an important challenge for advisors. They need to address the constant friction between impulsive human behaviour, and an investment plan that can take decades to unfold.

But with better knowledge and the help of sophisticated tools to assess risk, Murphy says an advisor can mitigate these impulses and strengthen a client’s commitment to investing.

“Can you help your client develop the psychological tenacity to handle bumps in the road? If you can, you will reduce surprises and meet expectations – and this will build trust, which will lead to referrals, more business, and a virtuous cycle that will ultimately benefit both the client and advisor.”