Turning Risk Tolerance from a Checkbox to a Competitive Advantage
19 October 2023
For decades, the standard for financial risk tolerance was a thin, seven-to-12-question quiz with multiple choice responses and nebulous at best results, wherein most people would be categorized as “moderate.”
The results didn’t help clients make better decisions, and offered next to no direction or insight for advisors
It’s understandable, then, that advisors treated risk tolerance questionnaires as an internal compliance requirement to be checked off– not a baseline for establishing a sound financial plan – and relied instead on conversations to gauge their clients’ risk appetite.
As the industry has evolved toward a more holistic approach to financial planning, largely driven by the catalyst of increasing client expectations, risk tolerance questionnaires and risk tolerance itself as a practice have also progressed. Big names have put risk tolerance on the map, but even these well-known behemoths still don’t take into account the full picture of risk.
They measure risk tolerance in a one-dimensional way, taking into account a client’s willingness to accept risk but not their ability to take on risk.
That’s the foundation of what makes Tolerisk so different. Using the SEC’s two-dimensional risk tolerance directive as a prescriptive model of what risk tolerance should be, we’ve pioneered the ability to objectively, scientifically and mathematically measure the ability to take on risk and illustrate a comprehensive, much more realistic picture of one’s future financial situation.
I’m here to tell you this isn’t easy to do, which is perhaps why, to this point, no one else has been able to replicate our capabilities or rigor. Measuring the ability to handle risk over time requires incorporating dynamic risk scores that change as financial situations evolve. We’re also able to consider historical scenarios for assets and inflation, enabling us to create more accurate paths for real returns – a better measure of financial longevity. Finally, we factor in the uncertain lifespan of both partners using mortality probabilities which can even incorporate age, gender, and various health and lifestyle factors.
The complexity that makes our solution so effective, thorough, and reliable, though, shouldn’t translate to difficulty communicating its results to the client. Other tools on the market use their own proprietary scoring models – scales from 1-7, for example, or 1-99, which don’t correlate to anything outside of the tool itself.
Put more simply, the client has no context through which to understand them. Because Tolerisk uses a standardized scale based on a total stocks and total bonds equivalent benchmark, advisors can much more clearly explain risk tolerance results to their clients.
For example, if a client has a risk tolerance score of 70, meaning a risk level equivalent to a diversified 70-30 stock-to-bond benchmark portfolio, that’s easily digestible and simple to articulate – much more so than trying to make a risk score of 62 on a scale from 1-99 make sense.
Why is this all so important to an advisor’s practice?
Unlike simply checking off the risk tolerance questionnaire box as advisors have done in the past, this sophisticated, multi-dimensional and dynamic approach turns risk tolerance into a powerful growth, retention, and protection tool for firms.
Let’s think, for example, about a common client concern: “Am I going to run out of money?”
Even if the answer is no, not in a million years, there’s a big difference between an advisor saying, “Just trust me, you’re never going to run out of money,” versus showing the client the calculations that prove they have less than a 1% chance of running out of money.
The latter builds trust by enhancing a client’s impression of their advisor’s diligence, intelligence, and customization capabilities, driving up the possibility of retention and referrals, while decreasing the chance that a client might lose confidence in their financial path.
When it comes to interacting with prospects, such a thorough, yet easily digestible, risk tolerance display increases confidence that an advisor is going to be able to offer sound, methodical guidance and navigate unexpected financial challenges.
Finally, from a compliance perspective, a highly scientific approach to risk tolerance creates a process that’s objective, repeatable, and documentable, offering consistency from client to client and advisor to advisor.
I encourage modern advisors to reimagine the way they think about risk tolerance. When it’s done well, it can be a significant advantage for growing firms.
If you have any questions, or just want to chat about risk tolerance, feel free to shoot me a message on LinkedIn here.