When working with an individual client, a financial advisor must consider the client's willingness and ability to take risks. Every situation is different: some wealthy clients may be reluctant to take chances, while those with fewer assets may be eager for a chance at high returns.

A suitable portfolio should consider both the investor's willingness and ability to take on a certain level of risk. It is essential that both these criteria be met. It is also necessary for the investor to understand the nature of the risks and the possible consequences.

Understanding Risk

In finance, risk is defined as the likelihood that the actual outcome from an investment will differ from the expected returns. When creating a portfolio, an investor (and their financial advisor) should understand what risk factors come with each type of asset, as well as any unknown factors that could also come into play.

While risk is inherent to the market, not all risks are created equal. For example, fixed income instruments such as bonds are generally considered safer than equities, but a blue-chip stock may be less risky than a poorly-rated junk bond.

Risk Tolerance vs. Risk Capacity

Risk tolerance is often confused with risk capacity, but the two concepts are quite distinct from each other. Perhaps the simplest way to understand the two is to consider them as opposing sides of the same coin.

Risk Tolerance

When a financial advisor deals with a client’s risk tolerance, the advisor is determining the client’s mental and emotional ability to handle risk. This means understanding and respecting the level of investment or financial risk that a client is comfortable with, or the degree of uncertainty that the client can withstand without losing sleep.

In general, risk tolerance tends to vary with the age, financial stability, and investment goals of each client. Advisors sometimes utilize questionnaires or surveys to get a better grasp of how risky an investment approach should be. The opposite of risk tolerance is risk aversion. If an individual would rather miss out on potential gains than take the chance of losing money, that client is relatively risk-averse. Conversely, if an individual expresses a desire for the highest possible return, and is willing to endure large swings in portfolio value to achieve it, this person is a risk seeker.

Risk Capacity

The other side of the coin is risk capacity, or the ability to take on risk without endangering the client's long-term goals. This is somewhat more objective than risk tolerance and can be determined based on the type of assets in the client's portfolio.

The financial advisor must review a client’s portfolio, using financial metrics to determine how potential losses will affect the client's bottom line. Risk capacity is constrained by several aspects such as a client’s potential need for liquidity, or quick access to cash, along with how quickly the client needs to meet their financial goals. Risk capacity is evaluated through a review of assets and liabilities. An investor with many assets and few liabilities has a high ability to take on risk. Conversely, an individual with few assets and high liabilities has a low ability to take on risk. For example, an individual with a well-funded retirement account, sufficient emergency savings, and no debt, likely has a high ability to take on risk.

Types of Risk

The most familiar types of risk are those that can be measured directly. For example, the probability that a winter storm will affect shipping or crop yields can be reliably calculated, based on observational evidence. Other risks are harder to quantify: there is no reliable way to measure the chance that lawmakers will pass a new trade restriction, or that equities will enter a bear market. Still, even an imperfect understanding of these dangers can help investment professionals choose the best assets for their clients.

The following are some sources of risk, and some common mitigation strategies:

Liquidity Risk

Liquidity risk refers to the danger that the client may need to cash out their assets at short notice. This is not always a necessity, but most investors still find it comforting to know that they are able to cover sudden or unanticipated costs.

Liquidity risk varies among different investments. For example, a financial advisor may advise private equity investments for clients who are less concerned with fast access to cash, allowing the potential for significantly higher returns. On the other hand, clients concerned about liquidity would benefit from investments in exchange-traded funds (ETFs) and high-cap stocks, that can readily be liquidated for their fair market value.

Market Risk

Market risk is the danger that asset prices will fall, either due to declining investor expectations of a certain asset, or as part of a wider downturn. The Dotcom bubble and Great Recession are classic examples of market risk, in that even highly-rated stocks suffered from falling prices.

Market risk can be mitigated by diversifying one's portfolio, especially among assets that are not correlated. This does not eliminate market risk, but it makes it less likely for all of the assets in a portfolio to go down at the same time.

Regulatory Risk

Regulatory risk refers to the danger that the government will take enforcement actions against a certain company or sector, causing prices to tumble. This risk is particularly pronounced in the banking and tech sectors, where several major companies have been accused of breaching antitrust laws. Cryptocurrencies are also facing significant regulatory risk, and it is not certain which digital assets may be considered unregistered securities.

The Bottom Line

Financial advisors are entrusted with their client's most precious assets, often representing decades of savings. However, there is no one-size-fits-all when it comes to investing. Only by carefully studying each client's financial position and risk preferences can an advisor help their clients create a portfolio that truly represents their client's best interests.