Learn how to make the most of your firm’s standardized questionnaire.

And take a look at a customized questionnaire.

How would you rate most risk-profile questionnaires?

  1. Vague and hypothetical
  2. Designed to protect the firm, not clients
  3. At risk of inappropriately classifying clients
  4. Effective and crucial

If you answered D, you’re in select company. For many advisors, risk questionnaires breed cynicism and disillusionment.

“The industry is woeful at categorizing risk for a client,” says Lenore Davis, senior partner at Dixon, Davis & Company in Victoria, BC. “The language is vague; the options are too broad.”

Subpar risk profiling can cause advisors to over- or under-diversify portfolios.

Chet Brothers of Brothers & Company Financial in Regina, says clients often come to him after filling out questionnaires for two or three previous advisors, each of which resulted in different risk profiles.

So he bases his approach on conversations, rather than asset-allocation programs that place premiums on diversification and can lead to clients owning thousands of securities.

“I try to simplify their investments, so clients know what they own. That helps them understand why they own them and [how they help] withstand market volatility,” he says.

1. Develop a definition

Risk comprises three distinct layers:

  1. Capacity measures the client’s ability to absorb a market decline without harming her quality of life. This is measured quantitatively, through questionnaires and simulators, using information such as assets, liabilities, predictability of income, amount of emergency cash, number of dependants, fixed and variable expenses and insurance coverage.

  2. Attitude (or tolerance) measures a client’s willingness to accept the potential fear and anxiety that accompany risk. It’s assessed through standardized questions, such as, “When faced with a major financial decision, are you more concerned about the possible losses or the possible gains?”

  3. Perception (or preference) gauges how much clients know about investing and how they view the riskiness of various kinds of investments. This can change over time.

If you asked a client before the 2008 crash where markets would’ve gone in the next year or two, she would’ve given you a different answer than if you asked in 2009. This is the form of risk over which advisors have the most influence, because they can bring experience with market cycles into play.

Yet “most questionnaires are simply risk-preference questionnaires,” says Tom Idzorek, president and chief investment officer at Morningstar Investment Management.

“Too often, these questionnaires don’t even touch on the subject of risk capacity,” he adds. “In an environment where advisors are forced to adhere directly to the outcome of these questionnaires, there is a lot of room for error.”

Paying attention to risk capacity shifts an advisor’s focus to address human capital, which factors your client’s source of income into the risk profile. So, when asking for a client’s income, also ask how he makes that income and how stable his jobs have been, or will be.

“If you’re a teacher, government employee or judge, your human capital is [relatively] safe,” says Moshe Milevsky, finance professor at York University’s Schulich School of Business. He contrasts that safety with an entrepreneur or someone whose income would be affected by a drop in stock-market or real-estate values.

You can get a sense of clients’ comfort levels by asking whether they prefer a salaried or commissioned job. Also ask if clients have borrowed money to make investments (other than mortgages).

2. Choose your strategy

Should you design your own questionnaire or rely on a standard one? Those who develop custom versions often do so out of disillusionment.

“Questionnaires are too often designed to protect the firm, not the client, so I made my own,” says Derek Moran, a fee-for-service planner at Smarter Financial Planning.

The survey has clients fill out four pages of detailed information about assets, liabilities, real-estate holdings, insurance and monthly cash flow and expenses. It covers the client’s own data, plus that of spouses and family members, and details which items are shared between them.

The questionnaire asks clients to classify assets under 18 separate categories, while a full page on cash flow includes monthly expenses on, among other things, tobacco, alcohol, haircuts, medications and house maintenance.

Health is one of the most important, so ask about any out-of-the-ordinary cash flow and budget lines (such as high medical expenses).

“I’ve done significant planning for a client, and then it’s come to my attention that she’d just had her third heart attack in seven months,” says Davis. They think it has no bearing on their investments.

So ask about any pre-existing medical conditions, or potential issues, in each of your discussions. “I meet clients three times a year, and each conversation opens with ‘What’s new? What’s changed?’ ” Davis says.

3. Real scenarios

“We talk about ability to take on risk by saying, ‘You’ve put money away in order to buy a condo for your child going off to university in three years,’ ” says Davis. “If you opened that box in three years and it was worth much less, how would you feel? What would you do to the other boxes in your financial plan?”

That kind of conversation is more effective than asking generic questions about how a client would react to a 50% drop in portfolio value.

Other scenarios to test include how the client’s portfolio would be affected by a significant drop in wealth (from a fall in the markets, or a 20% decline in property value), inflation or an unexpected change in income (getting fired).

“Scenarios are incredibly powerful; more than statistics and graphs,” Milevsky says.

Christopher Mason, a Toronto-based financial writer