Risk Tolerance: Why Advisors, Investors Mess It Up

The concept of risk is fundamental to investment planning. Investors with higher risk tolerances are willing to take a greater amount of risk in order to achieve their financial goals, and those with lower risk tolerances are not.

But quantifying the amount of risk that a client is willing to take can be a deceptively difficult task, at least in some cases. While many advisors employ the use of questionnaires and other similar tools to determine this trait in their clients, finding a client’s true risk tolerance can require analysis on a deeper level. Here's why. (For related reading, see: Determining Risk and the Risk Pyramid.)

Although most analysts use the past performance of an investment to project future results, this approach does not always work when advisors try to determine the risk tolerance of their clients. This is because recent market activity may stand out a great deal more in the client’s mind than long-term performance, and this can color the client’s risk tolerance inaccurately in many cases.

For example, clients who endured the losses that came with the subprime mortgage meltdown of 2008 were often inclined to swear off stocks forever. But those who did lost out in the long run, as the markets have since more than recovered from that debacle. But a risk tolerance questionnaire that was presented to clients shortly after this occurrence was often answered with deep skepticism about the market, despite the fact that it was only following its historical pattern.

Most respondents of risk tolerance questionnaires will remember recent market activity more vividly than more distant memories—except for those really bad times when their portfolios declined by a substantial percentage. This means that the answers to many risk tolerance questions are often based on incomplete experience and perceptional bias, and this can cause these questionnaires to become less useful.

The core issue here is that risk tolerance is essentially an unchanging factor for most clients—like the fundamental traits of their personalities. Their perception of risk, however, will typically fluctuate with the markets’ current or recent performance, and this perception often finds its way into the answers of risk tolerance questionnaires. (For related reading, see: Risk Tolerance Only Tells Half the Story.)

Tyler Nunnally, the U.S. strategist for FinaMetrica, a company that specializes in testing for risk tolerance, explains how this works. "Risk perception is a state of mind and can be volatile," he said. "Risk tolerance is an inherent behavioral trait, like introversion or extroversion, and as such it is rather stable over time. The point of risk-tolerance assessment is to make sure that clients are emotionally comfortable with investments in good times and bad so that they avoid the pattern of buying high and selling low and can stick with their financial plans."

His company distributes a series of psychometrically-based risk tolerance tests to financial advisors, institutions and individual investors that map out a range of risk tolerances, from conservative to aggressive. The questionnaires ultimately help users determine the types of investments that they will be comfortable with through the ups and downs of the markets. Nunnally states that a properly crafted risk tolerance questionnaire will elicit the same answers if it is retaken in the future. Of course, some investors who become more comfortable with risk over time will change their answers accordingly based on their experience. Clients who see good results in their portfolios may become more comfortable taking a larger amount of risk.

However, not all advisors are advocates of using questionnaires to get a true evaluation of a client’s risk tolerance. Many of them feel that clients’ answers to those questions are too biased to be reliable. Rob Brown, a chartered financial analyst who works as the chief investment officer at United Capital, feels that many risk tolerance assessments only function as CYA documents for advisors, and many psychologists and other academics consider risk tolerance questionnaires to be a lot of bunk. (For related reading, see: Do You Understand Investment Risk?)

"When you work with human beings, you understand that risk is a complex, nuanced matter," said Brown. "It is a dynamic, living phenomenon. To characterize it as a one-dimensional, static number ends up doing more harm than good." Brown says these tests can yield results that are too bullish or bearish for the client’s own good in many cases because of their bias from recent market and portfolio performance. He also maintains that clients should work with a financial advisor to create a financial plan that takes their ultimate goals more into account than their risk tolerance. According to Brown’s viewpoint, clients who build portfolios based upon risk tolerance are allowing their tails to wag the dog.

Risk tolerance will always be a foundational building block of a client’s investment portfolio. But finding out the amount of risk that a client is really willing to take may require more than the completion of a simple questionnaire, and advisors may be wise to employ the use of more sophisticated tests that can unearth deeper information about their clients’ appetite for risk. (For related reading, see: The Seasons of an Investor's Life.)