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The purpose of risk questionnaires is to identify a proper allocation of securities given the investor’s risk preference. A typical risk profile assessment asks a series of multiple-choice questions about the investor’s time horizon, investment experience, and portfolio preferences. There might even be a few “what if” questions. The end goal is to suggest an allocation of securities commensurate with the investor’s risk tolerance (or risk appetite).
Unfortunately, risk profilers are not as robust as you would think, or hope. They suffer from two fatal assumptions: that the investor is rational (not true), and that risk is static (also not true).
Risk profilers see investors as how they should behave and do not account for how we really act. For example, many questionnaires ask investors how long it will be until they need the money. The greater the number of years, the higher the calculated risk tolerance (and greater exposure to equities). The thinking is that a rational investor that doesn’t need their money for 20 years can handle significant fluctuations. But therein lies the problem; the investor isn’t rational.
Of the clients that ask you about news headlines, what the market may do this year, or concerned about recent portfolio performance…how many of those are long-term investors? All of them? Our time horizon has little to do with the fluctuations we can psychologically handle. Perhaps a better question would be, “How often will you watch the market and evaluate your portfolio?” The more frequent, the lower the risk score and vice versa.
“Deliberate avoidance of exposure to short-term outcomes improves the quality of both decisions and outcomes.” [1] – Daniel Kahneman
Another common risk profile question will ask the investor to select one of several portfolios, ranging from conservative to aggressive. The conservative portfolio will have a low annual rate of return with greater stability in returns. The most aggressive portfolio will show a high average rate of return with significant fluctuations from year to year. The challenge here is that investors aren’t feeling what it’s like when markets and portfolios are down 25%. They aren’t being bombarded with negative news, dire outlooks, and the uncertainty of how much further and how much longer losses may continue. They aren’t thinking about how brutally hard it will be to hold on. This may cause investors to select a portfolio that in which they want the high annual returns but cannot psychologically handle.
An additional flaw with risk questionnaires, which is seldom discussed, is that our risk tolerance is not static. Imagine taking a risk profile questionnaire when the market is down over 20%, companies are laying off employees, analysts are slashing estimates, and more losses are predicted in the future. In other words, imagine you are filling out a questionnaire when fear, anxiety, and hopelessness abound. Compare that to filling out a risk questionnaire after your account has gone up in value, analysts are talking about the strength of the bull market, and how much further it has to go.
It doesn’t take a genius to realize the responses would be very different. Our perception of risk is greatly influenced by our mood and emotions, which in turn is influenced by our physiology. Just like a corporate balance sheet, a risk tolerance questionnaire attempts to define your risk preference on a given day and is subject (and likely) to change as circumstances change.
That’s not to say risk tolerance questionnaires serve no purpose. They can help define a starting point to discuss risk with your client, but by no means should be viewed as a flawless tool. A comprehensive assessment of your risk tolerance and subsequent allocation should include several conversations about your clients’ financial and psychological ability to tolerate losses – given their past experiences, behavioral biases, and financial constraints.
To improve the accuracy of risk assessments, compliment it with a robust behavioral profiler, which asks questions to identify certain biases and provides tips on how to understand your clients’ true risk preferences and coach them with helpful perspectives. I created a behavioral profiler that will be in a book I am currently writing, and will be available for advisors this summer.