Mark Slater knows that financial adversity can sometimes be the truest indicator of an investor's real risk tolerance.
Mr. Slater, an investment advisor with CIBC Wood Gundy in Toronto, recalls how back in 2007 a couple who were then in their mid-40s "came in with what they thought was a solid plan. They felt they had a long enough time frame and wished to maximize the return potential by having 100 per cent of their portfolio in equities."
But what those investors, along with many financial experts, didn't see coming at the time was the most severe financial downturn since the Great Depression of the 1930s.
"As the financial crisis took hold in 2008 and they saw their portfolio fall 30 per cent, and take almost three years to recover, they realized that their comfort level with this kind of risk tolerance wasn't what they had originally envisioned," says Mr. Slater.
As a result of that experience, Mr. Slater helped his clients adjust their portfolio, putting a portion of the balance into fixed-income investments to insulate it from market fluctuations.
"They now sleep much better knowing that the next time a major market correction happens, their savings won't have to experience the same type of market swings," he says.
Amy Dietz-Graham, an investment advisor and portfolio manager with BMO Nesbitt Burns in Toronto, also saw how the financial crisis became a moment of truth for clients' understanding of how much risk they were willing to accept.
"If markets are booming and things are going well, people tend to underestimate their level of financial risk," Ms. Dietz-Graham says, in noting how that can also provide a false sense of security.
"It's only when things switch – and 2008 served as a really good touchstone – in [that] I think a lot of people took on a lot of risk, but they really weren't aware of how much risk was in their portfolio til it was too late," she adds.
Ms. Dietz-Graham also notes that she will often meet with young professionals who have the mindset, "I've been told I'm supposed to be more aggressive at this stage of the game," and who take on extra investment risk as a result. But when times get tough, they want to sell, because they don't understand what they're invested in, she says.
Risk tolerance, and an ongoing assessment of how that changes over time, is a critical element in the financial advisor-client relationship. A skilled financial advisor can help articulate what level of risk the client is willing to accept. The stakes are high because ultimately people are saving to achieve a measure of financial independence and dignity in retirement when the money has to last.
And everybody will have a different path to achieve their goals. One client might be 30 years old and want to get into a position to be financially independent enough to retire at age 60. Another might be 40 years old and be looking to achieve that same goal by age 65, says Mr. Slater.
"Sometimes if you ask the question 'What's your risk tolerance?' somebody might say 'Low.' But [the definition of] 'low' to somebody might be different to somebody else. So I push further and say 'Describe that to me – what does that look like?'" says Ms. Dietz-Graham.
A big part of that conversation when speaking with clients and asking questions also involves probing to find out how they handled difficult situations like past market downturns – whether, for example, they viewed them as an opportunity to buy or whether they panicked and sold, Ms. Dietz-Graham adds.
The client's perspective can change as they go through life's various circumstances, which can help to cement an intimate bond with their financial advisor over time.
"I think what drives it for me and my clients is it comes down to having a trusted relationship that goes both ways," says Kristine Douglas, a certified financial planner with Investment Planning Counsel in Toronto.
"They are updating and informing me about their life, and my expertise is in drawing out potential critical financial events that may occur, or after they have occurred – things like marriage, divorce, illness, a new house, inheritance, a change in job. All of these things are critical financial events that would potentially change their financial plan," Ms. Douglas elaborates.
Underlying wealth can also affect the level of risk tolerance. For example a 60-year-old with the safety net of $1-million in savings and a retirement pension from work will be in a different position in terms of their ability to take on risk from market volatility than another 60-year-old without those advantages, Mr. Slater says.
How often investment plans should be reviewed for risk tolerance can vary, depending on factors such as age, since the closer one gets to retirement, the less time and opportunity there will be to recover from a market drop. But changing circumstances throughout life also create situations where it behooves younger people to re-evaluate, say experts.
"We generally review financial plans on a yearly or a semi-annual basis, or any time there's a life change. That financial plan includes all the different short-term and long-term goals the clients have, and the different risk tolerances that each of those goals may take," says Mr. Slater.