Determining a client’s risk profile can be a challenge—just ask any investment professional responsible for this task. This particular task, however, has been identified as the most important building block of a successful investment plan, according to industry experts.

In April, CFA Society Toronto’s Private Client Committee invited three industry veterans to participate in a discussion on effective risk profiling. Don Cranston, founder and portfolio manager of CGOV Asset Management; Philip Doyle, investment counsellor at Burgundy Asset Management; and Brad Simpson, chief wealth strategist with TD Wealth offered sage advice about effective risk profiling of clients. They covered a range of topics, from client expectations and needs to behavioural biases, as well as providing tips and tools for using risk questionnaires appropriately—all of which are important in assessing a client’s capacity to take on risk. The following is a summary of their discussion.

Why risk profiling is important

Understanding your client’s risk profile is essential to determining their investment suitability. Applying this knowledge will ensure the portfolio is structured to your client’s needs. Furthermore, it will help you, as the investment professional, to understand your client’s ability to live with a portfolio through the good and bad markets. Risk profiling also reminds us that human behaviour isn’t rational. Remember, a large portion of the investment business is built for institutions; when you service private clients, stay mindful of the human aspect of investing.

Helpful tips to guide the conversation when determining a client’s risk profile

If you’re working with a new client, ask them to provide an overview of their investment history, and pay close attention to their reactions. Avoid the classic, closed-in questions such as Would you say your risk tolerance is, high, medium, or low? Instead, focus more on open-ended, probing questions such as Why are you here today? These types of questions are very important, and can reveal a great deal about your client’s capacity to take on risk.

Be aware of interviewer bias, as well as how you ask questions to your client, as your bias may have unintended influence on your client’s responses. Finally, try to keep everything in dollar terms—especially when talking about portfolio decreases—as many people have a hard time relating to percentage.

Understand your client’s needs, capacity, and goals

For most private clients, money is a means to an end, not an end itself. Ask your client the following: What is the money here to do? How much do you need to meet your obligations, to pass on to your family, to give back to society? Don’t rush to investment before fully understanding your client and their needs and goals. Take a look at your client’s financial capacity to achieve their desired outcome. Set realistic expectations and resolve any risk/return disconnects, such as what might happen if your client doesn’t or can’t meet their goals. Be mindful of emotional risks. Think about client suitability and the risks of taking on a client that may not be a good fit for your firm.

An honest conversation around risk is a critical component in building a strong and trusting relationship. And while you can’t know for sure how your client will react to a downturn in the market, you can increase the probability of knowing their reaction through the use of quantitative and qualitative risk-profiling tools.