Risk profiling is a process for finding the optimal level of investment risk for your client considering the risk required, risk capacity and risk tolerance, where,
- risk required is the risk associated with the return required to achieve the client’s goals from the financial resources available,
- risk capacity is the level of financial risk the client can afford to take, and
- risk tolerance is the level of risk the client is comfortable with.
Risk required and risk capacity are financial characteristics calculated using your financial planning software. Risk tolerance is a psychological characteristic which is best determined by way of a psychometric test.
Risk profiling requires each of these characteristics to be separately assessed so that they can be compared to one another. Risk capacity and risk tolerance both act separately as constraints on what your client might otherwise do to achieve their goals (risk required). It is unusual for a client to be able to achieve their goals from the resources available within both their risk capacity and risk tolerance.
Where a mismatch between risk required, risk capacity and risk tolerance has been found, the advisor’s role is to guide the client through the trade-off decisions that are required to reach an optimal solution.
The final step in the risk profiling process is to ensure that the client has realistic risk and return expectations so that the advisor can be given the clients properly informed consent to implement the investment strategy.