Mark Coutts, Sun Life financial adviser, remembers the day when a husband and wife who just sold their home walked into his office with a stack of cash and asked for his help investing it in such a way that they would feel at ease.
"They said, 'We're low-risk investors and we're very comfortable with that. It gives us peace of mind and we sleep at night'," he recalls.
It only took ten minutes of "back-of-the-napkin math" for Mr. Coutts to realize this couple needed to create an income stream for retirement, which required a 5-per-cent rate of return on their portfolio. And in this market, that requires a much higher risk tolerance, knocking them out of their low-risk comfort zone.
"Looking at their faces you could see this epiphany as it dawned on them that being low risk and having that comfort level may not be doing them any good," he says. "It may allow them to sleep at night, but if they run out of money midway through retirement, then what good has having a low-risk portfolio done?"
The story is not unique. Both newbie and seasoned investors often do not understand what having a low-risk investing tolerance could mean for their long-term financial goals. Letting their emotions or fears guide their money decisions is dangerous, according to experts, any of whom recommend a tailored balance between risk and returns.
There are online tools that can help an individual start the process of identifying his or her risk tolerance, but financial advisers say these instruments do not go far enough.
"You need to have a frank conversation because an adviser can't simply accept a client's statement that 'I'm a low-risk investor and that's the end of the conversation,'" says Mr. Coutts. "An adviser's job is to say, '…lets take a look at that low-risk portfolio and you may, in fact, be self-sabotaging your own retirement.'"
Running out of money is, in fact, a risk factor investors should take into account, says Mark Bayko, head of multi-asset, portfolios & practice management at RBC Wealth Management.
"It's not just about volatility or loss, it's also about: 'Are we going to have enough?'"
For him, risk assessment goes beyond the markets and should start with a financial plan that clearly establishes what clients need out of their investments.
"Is it capital preservation? Do we need income off of this being generated every month or do we need to get to someplace over the next ten years and grow by a certain amount?" explains Mr. Bayko.
Market volatility and longevity are not the only risk factors to consider.
"Don't be fooled by an investment product that is labelled low-risk," cautions Lori Pinkowski, co-founder and senior portfolio manager of Pinkowski-Allen Financial Group of Raymond James Ltd.
For instance, investors may not understand the impact that inflation can have on their investments – especially on traditional lower-risk debt instruments, explains Ms. Pinkowski.
As an example, consider an investment in GICs, with a rate of return of 2 per cent annually. Factoring in an inflation rate of 2 per cent, it would mean the rate of return is actually 0 per cent. And adding in the taxes on top of that, an investor could actually end up with a negative rate of return.
So, to keep lower-risk vehicles out of the red, investors would have to adjust their risk tolerance.
The same goes for bonds, explains Ms. Pinkowski. "Bonds have traditionally been considered low-risk, but with interest rates on the rise in the U.S., investors could see negative returns with the bonds they hold."
"I believe there are varying degrees of risk with any investment product and the risk level will depend on the market environment," she says.
Indeed, risk assessment is a complex issue from many angles, including the questionnaires many financial institutions use to assess a potential client's tolerance.
A 2015 study commissioned by the Investor Advisory Panel (IAP) of the Ontario Securities Commission revealed that many risk assessment questionnaires are flawed, even though between 76 and 100 per cent of adviser's clients used them. The report noted that only 16.7 per cent of these questionnaires are "fit for purpose," due to a list of issues that includes poor wording, lack of clarity and poor scoring models.
Connie Craddock is a member of the IAP and says the group often heard complaints about these assessment tools, which prompted them to dig deeper into their make-up and function.
But she adds that, "We're optimistic that there is an opportunity, using this research data, for the practices to be improved in Canada."
It all comes back to seeking professional help, says Mr. Coutts, and making sure an in-depth conversation is part of the risk assessment, so there is a clear understanding of what that means for the client.
"If I had a nickel for every time an investor says, 'Oh I can handle market volatility.'"