Why risk tolerance, not just risk capacity, should drive advice

Behavioural research paper suggests steps for advisors to strengthen clients’ financial plans and mitigate risky decisions

Why risk tolerance, not just risk capacity, should drive advice

While advisors can ensure they provide suitable advice by looking at their risk tolerance, that only represents half of the risk picture.

In a recently released Behavioural Finance Industry Report, researchers from TD Wealth and the University of Toronto’s Behavioural Economics in Action Research Centre at Rotman (BEAR) made the distinction between risk capacity and risk tolerance. While risk capacity refers to one’s objective ability to take risk, risk tolerance is one’s behavioural willingness to take risk.

“The role of an experienced advisor who goes the extra mile to understand the psychological and behavioral factors of a client’s individual risk tolerance can be equally as important as the awareness of their risk capacity,” the report said.

Overconfident, highly extraverted investors could express a willingness to take on highly volatile investments even though they have neither the capacity nor the tolerance to do so, the report said. To fully grasp their client’s risk tolerance and minimize the risk that they are holding a portfolio that falls outside that zone, the report suggested that advisors use evaluative techniques or fulsome risk questionnaires. Clients who prove to be highly extraverted, the report said, may need to be reminded of the potential future downsides that come with the prospective upside of risky investments.

One key finding of the research is that people who work in volatile industries or have a volatile income were more likely to have a volatile portfolio, and were also more prone to being highly reactive and less conscientious; lower conscientiousness, the authors added, was associated with lower self-discipline, planning, and order.

In a 2017 report, research from TD Bank Group found nearly 37% of participating adult Canadians experienced moderate to high income volatility over the previous year, with segments such as the self-employed, millennials, and mature Gen-X men being most likely to experience it. Another study from CPA Canada in 2019 found that self-reported volatility in income was a predictor of lower financial capability as indicated by trouble making ends meet, difficulty in planning ahead financially, and trouble with choosing financial products and services, among other negative outcomes.

“As an advisor, the preparation of a plan with action steps and tracking, plus regular behavioural coaching could be vitally important,” TD Wealth said in its recent report, noting that those living through volatility in their employment or income are 55% less likely to say they were very satisfied with their readiness for retirement.

The paper also underscored the importance of advisors educating their clients, particularly in helping them understand the trade-offs arising from the reduced probability of meeting goals, or reducing their current lifestyle in order to save more – risks that aren’t reflected in investment products’ risk ratings, which focus on investment performance volatility over time.

Crucially, the research from TD Wealth and BEAR found that people who scored as more reactive also scored lower on their self-assessed investment knowledge and experience. To help reactive investors, and all clients in general, advisors can provide factual education to help clients navigate wealth management as well as short-term market events when the risk-reward relationship is especially relevant.

“Many good advisors coach clients to avoid behaviours that might be detrimental to their long-term goals … At these times the advisor may feel more like a financial therapist than a financial advisor,” the report said. “Helping their clients feel more emotionally comfortable with their portfolio is essential as these types of behavioural errors could become costly for the future.”


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