Bridging the Risk Gap: An Ongoing Journey for the Client and the Advisor

By Tim Kochis and Akhil Lodha

In the ever-changing world of financial planning, one constant remains: the imperative to align a client’s risk profile with their investments. This not only ensures the long-term success of a financial plan but also establishes and maintains the relationship of trust between the advisor and the client. In this article, we explore the nuances of risk assessment and how technology plays a pivotal role in this process.

One of the most significant technological advancements in recent years is the use of software solutions that facilitate risk assessment. These tools enable financial planners to better understand their clients’ risk tolerance and capacity, streamline the planning process, and better ensure compliance with industry regulations.

Understanding Risk Tolerance and Risk Capacity

The interplay between risk tolerance and risk capacity is fundamental to creating and maintaining a successful financial plan for clients. Risk tolerance refers to the psychological aspects of risk-taking, which are influenced by a client’s personality, experiences, self-image, and, of course, financial goals. Assessing clients’ risk tolerance is crucial in determining an appropriate investment strategy. For example, a risk-tolerant young entrepreneur may be eager to invest heavily in start-ups, while a risk-averse retiree may prefer a much more conservative approach, focusing on bonds and dividend-paying stocks. In between these conventional extremes lies a very broad range of actual “comfort zones” that clients are willing to occupy.

On the other hand, risk capacity is the financial ability of clients to withstand losses, determined by factors such as net worth, cash flow, and investment horizon. Assessing clients’ risk capacity ensures that they can weather market fluctuations without jeopardizing their key financial goals. For instance, an investor with a high net worth relative to the requirements of their goals and a long investment horizon has a greater risk capacity. They can invest in riskier assets than an investor with a tighter relationship between resources and goals and with a short investment horizon, who probably needs to opt for less risky investments to protect them from failure to achieve their objectives.

Tim’s experience with a high-earning couple who displayed a high risk tolerance but limited risk capacity illustrates the interaction of these two factors. This client couple had highly leveraged and illiquid real estate investments that negatively affected their risk capacity. By working closely with them, Tim helped the couple rebalance their portfolio over time to align it with their risk capacity, ultimately providing a more secure financial future.

In another case, Tim helped a client recognize their capacity for taking considerably greater risk with their investments. The prospective returns from that riskier stance permitted the development of even more ambitious goals without jeopardizing the existing core goals if the riskier portfolio failed to fully reach its targets.

The Evolving Risk Profile of Clients

Advisors know that clients’ risk profiles are not static; they evolve over time, due to various factors, necessitating regular reassessments and adjustments to financial plans. But even at the outset, the concept of risk tolerance is best seen as a “negotiated” conclusion, not an a priori, fixed input. Many clients announce themselves to be at a specific point on the spectrum of risk acceptance, only to learn that they can and maybe should change. That change is often caused merely by knowing that other choices are available and, most often, as our examples above show, by the facts of their actual risk capacity. That ongoing dance between tolerance and capacity is at the core of the advisory relationship.

Life events and changes in financial goals, as well as market fluctuations and economic developments, can significantly affect clients’ risk profiles. For instance, a couple with a high-risk investment strategy may need to reevaluate their approach following the birth of a child, as they may prioritize financial security and education savings over aggressive growth. Similarly, the 2008 and 2020 financial crises led many clients to reassess their risk tolerance and capacity as they faced job losses, market volatility, and plummeting asset values.

Regular reassessments and adjustments are essential to ensure that financial plans remain aligned with clients’ evolving risk profiles. Monitoring clients’ risk profiles and adapting financial plans accordingly can help them stay on track to achieve their financial goals while protecting their assets.

Through Akhil’s interactions with several advisors who use risk analysis software from StratiFi, where he is CEO, he learned about a client who had recently received a significant inheritance. Initially, the client’s investment strategy focused on aggressive growth. However, after reassessing her risk profile, the advisor recommended a more balanced approach that prioritized capital preservation and income generation, reflecting her newfound financial security and revised goals. Her new wealth permitted her to reduce her risk appetite. Her previous degree of risk was no longer necessary to achieve her goals.

Similarly, Tim encountered a client who had experienced a considerable loss in their business venture. This had a profound effect on the client’s risk capacity, forcing them to reevaluate their investment strategy. Tim helped the client shift from high-risk portfolio investments to a more conservative stance, reducing potential further wealth losses and providing the financial stability that had become much more vital. But, in another case, an unexpected inheritance permitted the client to take more risk in search of higher returns. These examples illustrate that a change in risk capacity can result in the client having either a higher or a lower risk tolerance.

These examples of the dynamism of a client’s risk profile—with more or less risk over time—highlight the importance of remaining vigilant and responsive to all the relevant changes in clients’ lives. This means not only to the impacts of market performance but also to changes in goals and, of course, to the mere passage of time. As financial planners, our role extends beyond the initial creation of financial plans; we must serve as trusted, ongoing advisors, guiding clients through life’s ups and downs and adapting their financial strategies to reflect their evolving needs and circumstances. By regularly reassessing and adjusting clients’ financial plans, we can help them navigate the complexities of risk management and better ensure the long-term success of their investment strategies.

Compliance Implications and SEC Enforcement Actions

Documenting client conversations is an integral part of maintaining compliance and managing the risk of potential enforcement actions. Clear and detailed records of client interactions, risk assessments, and portfolio adjustments demonstrate that financial planners are acting in their clients’ best interests and following regulatory requirements.

The SEC closely monitors wealth management firms and financial advisors, ensuring adherence to industry standards and taking enforcement actions when necessary. In 2020 alone, the SEC brought 715 enforcement actions, resulting in penalties and disgorgements totaling over $4.68 billion. Among these enforcement actions, several cases involved financial advisors and wealth management firms, highlighting the need for strict compliance measures in our field.

For example, the SEC charged a financial advisor in 2018 for misleading clients about the risks of a certain investment, ultimately causing substantial losses. Had the advisor maintained proper documentation of client conversations and risk assessments, they might have avoided the enforcement action or at least had a stronger defense during the SEC investigation. Without record-keeping, they couldn’t demonstrate that the client’s decision was a deliberate, well-informed choice.

Risk analysis software plays a vital role in compliance management, offering features and tools that streamline the risk assessment process and facilitate documentation. StratiFi and other risk assessment and risk management software attempt to provide platforms to simplify these processes and often provide reports that allow financial planners to track adjustments over time. Such audit trails enable advisors to maintain clear records of client interactions, a crucial aspect of compliance management.

By harnessing the power of risk analysis software and adhering to regulatory requirements, advisors not only streamline their practices and minimize their business risks but also better fulfill their responsibilities to the welfare of their clients.

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Tim Kochis, JD, MBA, CFP^®, has a 50-year career as a wealth manager and writer, speaker, and consultant. He consults with and invests in fintech companies, such as StratiFi. Akhil Lodha, founder and CEO of StratiFi, leads a risk and compliance tech platform used by RIAs for risk assessment, investor suitability, portfolio risk monitoring, and account surveillance.

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