For the first 20 years of his career, Jim King used risk tolerance questionnaires to match clients with suitable investments. That changed with the 2000-2002 bear market that followed the dot-com crash. "A client might have said he could take a 20% drop in account value," says King, who heads a financial planning and investment advisory firm in Walnut Creek, Calif. "But guess what? Fear took over. Those questionnaires didn't indicate how clients would feel in the midst of turmoil."

Similarly, Brent Brodeski, principal and CEO of Savant Capital in Rockford, Ill., asserts that the advisory business tended to be "naive" about risks 15 years ago, at the beginning of the recent spate of boom and bust cycles. "When discussing risk," he says, "we'd point to the Ibbotson charts on the wall. We'd tell clients, if you're in for the long term you can expect annualized returns of 10% in stocks, 12% in small caps and 5% in bonds." The more volatility clients could stomach, the higher the expected returns.

Reassessing risk. Fast-forward to 2012, after a decade-plus in which clients have seen innumerable rounds of irrational exuberance and merciless comeuppance, culminating in the stock market crash in 2008 and 2009. Savvy advisors have recognized that investment risk needs a more sophisticated examination.

"In our approach to asset allocation and risk tolerance, we definitely have seen an ongoing evolution accelerated by, though not caused by, the financial meltdown," says Russ Hill, chairman and CEO of Halbert Hargrove, an RIA advisory firm in Long Beach, Calif. "For example, we increased our internal capacity by forming an investment committee seven to eight years ago. This pulled us away from product providers' information, which had largely become a sales tool. That is, risk tolerance equals, 'I know you and you can trust me. I show you a modern portfolio theory pie chart and make a sale.' Rinse, repeat."

Simplistic risk tolerance questionnaires may not be capable of addressing all the risks facing today's investors. Mike Martin, principal and CIO at Financial Advantage in Columbia, Md., lists no fewer than five kinds of investment risk. Leading off is inflation risk: as Martin puts it, the high probability of a loss of buying power means that most people must invest instead of stashing cash under the proverbial mattress, and thus expose their assets to all the other types of risks.

Most advisors are familiar with three of the other risks, those specific to issuers, valuations and macro-economic factors; after the turmoil of the 21st century, so are most clients. To these, Martin adds the fifth, systemic risk-the chance that a world built on paper currencies, fractional reserve banking and liquid global markets for debt and equity securities will seize up and pound portfolios. "That's the greatest risk of all," he says, "and the one hardest to defend against."

As the definition of investment risk expands, advisors may seek more precise ways to grapple with multiple challenges. "We look at risk-related measures such as the Sharpe ratio to see how our clients' risk-adjusted returns compared to riskier portfolios," says Stephanie Lang, director of the investment department at Homrich Berg, a wealth management firm in Atlanta. "This allows us to see if taking on more risk was rewarded." If the risk seems to justify the potential payoff, Lang's firm will look for pockets of opportunity within broad asset classes to possibly provide extra return.

To measure risk now, Hill says, his firm uses the financial risk profiling method offered by Australian company FinaMetrica. "It's simple and seems robust," says Hill. "We require that it be redone every year as part of our annual report process."

The FinaMetrica test is more detailed than most risk-tolerance questionnaires. Respondents fall into one of seven categories. So a Halbert Hargrove client in, say, FinaMetrica's Group 5 might have a different asset allocation than a client in Group 3. But the actual allocation is based on client goals, objectives and needs-not on their risk tolerance scores.

"If the score diverges a great deal from our assessment of a portfolio that can realistically achieve what the client needs," says Hill, "it could prove a limitation." The likely result, according to Hill, would be a substantive discussion with the client about the necessary trade-offs and the differences among various risks, such as volatility risk and shortfall risk.

"Some clients cannot stomach volatility," says Lang, "regardless of whether it will pay off in the long term. For them, we use lower-risk models. The most important thing is to make sure our clients are meeting their financial goals."

Thinking tactically. If strategic investing (setting your portfolio according to Ibbotson and then holding on) has proved naive, as Brodeski says, then those who were naive may have still been able to survive the dot-com bust in 2000. But they wouldn't have survived the real estate financial crisis of 2008. "After this ordeal," he says, "a group of 10 advisory firms formed a 'tactical think tank' to see what we could have or should have noticed beforehand to avoid such a disaster." This group was headed by Gobind Daryanani, known as an expert on rebalancing.

The group of 10 eventually split into two subgroups, according to Brodeski. "One looked for triggers such as moving averages and head-and-shoulders charts that could have provided a warning," he says. "They didn't find a silver bullet-there was no consistent pattern that indicated when to move in or out of the market."

Brodeski's firm was among those in the other group, which was seeking a middle ground between immediate triggers and long-term buy and hold. "We realized that long-term results matter," he says, "but we also felt that today's interest rates matter, today's valuations matter and so on. We found that you can't predict short-term moves, but you can have some confidence about returns over the next 20, 10 or even five years."

Historical results fail to recognize the convolutions of recent years and current circumstances. Consequently, Brodeski now advocates what he calls "rebalancing with an octane boost." That might mean dialing up equities if overall valuation is appealing, but maybe dialing down REITs if they seem pricey. "Clients like it," he says. "Instead of just referring to the Ibbotson numbers, we give them [our firm's] analysis, combining historic trends with current conditions."

"We take a view on the market and overweight or underweight certain asset classes," says Lang, "depending on our outlook for economic growth and overall risks for the economy. We also look at valuations to see if anything is cheap and also weight asset classes accordingly."

Worst-case scenarios. Martin's firm sifts investment choices through the filter of his five risk categories (again, inflation risk, valuation risk, macroeconomic risk, the issuers' risk and systemic risk), attempting to reduce these by diversifying them.

"Currently," he says, "bonds have a serious valuation risk, so we're short-term. Stock valuations are not much more attractive, so we're at the low end of our asset allocation range. For U.S. equities, we own individual issues instead of funds; we want to pick specific companies with the potential for sales growth, even in a no-growth economy."

As for systemic risks, Martin is most concerned about what might be termed "D-struction": debt, deficits and depressing demographics among industrialized nations. "Well-run companies have people on the front lines," he says, "touching change and adapting their businesses. They will be best-equipped to survive if economic growth lags what we've experienced since World War II." Martin's clients also hold 10% in gold-linked investments as a hedge against currency depreciation, which might occur if central banks "put the pedal to the metal" to spur their economies.
Monthly measures. King also reports undergoing a change in the way he approaches risk in the wake of 2008's market meltdown. "We had been using standard deviation to measure volatility," he relates, "but that didn't tell the story well then. We had more days of 3% market moves in the last four months of 2008 than we had seen in the previous 20 years. It became obvious that clients' main concern was the reported loss of value in their accounts."
While King uses modern portfolio theory metrics such as the Sharpe ratio to gauge the risk of clients' portfolios, he has found another way to determine how much portfolio volatility a client can actually endure. "We're using maximum monthly drawdown," he says. "It's a number that's readily available and easily understood by clients. We try to find how much of a downside move a client can take."
In his current approach, King gauges a client's tolerance for risk in his introductory interviews. The clients are placed in one of five portfolios, with varying degrees of risk. In subsequent meetings, the monthly drawdowns are discussed so he can see the client's comfort level. "If necessary," he says, "we'll adjust the client's portfolio, moving to another model portfolio with a different risk level." Generally, taking on less risk means cutting clients' allocations to equities while increasing exposure to fixed income and market-neutral strategies.
Despite considerable market volatility so far in 2012, clients haven't expressed discomfort with their portfolio drawdowns. "This has been a stable year for our clients and their portfolios," says King. "We take that as validation that clients are in the right place."