When you meet a new client you want to know three things: their return objective, their time horizon and their tolerance for risk. You may want to know other things too, but these are the big three.
Calculating a return objective is pretty straightforward. The same is true about time horizon. You gather some facts, make some assumptions and ask the client to think about some things they probably haven’t thought much about. But, in the end, the calculations are pretty simple.
What about risk tolerance? How do you measure it? Can you calculate it at all?
It doesn’t take long to see that there are really two very different varieties of risk tolerance. One is objective and the other is subjective.
The objective variety is easy to understand. If I arrive at my retirement age with more money than I need to live comfortably, my goal should be to take as little risk as possible while maintaining the purchasing power of my assets. Objectively, I have no need to take risk.
On the other hand, if I arrive at my retirement age with significantly less money than I need, objectively I should have a higher risk tolerance. I need to take risk to reach my goal.
This objective type of risk tolerance determination has nothing to do with my internal feelings, attitudes or beliefs about risk. It is all driven by my goals and my time horizon.
Now let’s look at subjective risk tolerance. This is what risk tolerance questionnaires purport to measure by asking questions about our predisposition toward, and comfort level with, risk.
Some questionnaires synthesize our answers into a risk score. Some even use our risk scores to determine our investment strategy. Our comfort with risk drives which portfolio we receive.
These questionnaires assume that our risk tolerance is like an organ in our body that can be “seen” through an X-ray or MRI. The questionnaire is the tool that discerns risk tolerance.
This view is not consistent with the research on risk tolerance. A person’s tolerance for risk is hard to capture and harder to quantify precisely. You may get a general sense of a person’s comfort with, and capacity for, risk-taking, but assigning a meaningful risk score is impossible.
In addition, risk tolerance is fluid not fixed—it changes over time. Today’s bold adventurer is tomorrow’s timid soul. It is also situational. A skydiver may be conservative with her money.
The research also suggests that we are notoriously bad at assessing our own risk tolerance. Getting a sense of our risk tolerance by asking us produces unreliable results.
If we are not good at assessing our own tolerance for risk and that tolerance changes over time, what good is a questionnaire that produces a precise risk score at one moment in time?
A more difficult question is, “why is risk tolerance even relevant?” If a client needs to be aggressive in order to reach his goals, should you put him in a conservative portfolio just because he has a low risk score? The answer seems obvious. Risk, alone, should not drive strategy. Sometimes being a little uncomfortable is a necessary side effect of investing.
A discovery questionnaire can help an adviser solicit important information from a client and stimulate discussion to develop insights about the client’s goals, experiences and attitudes. But substituting a mechanical scoring system, backed by questionable science, for the judgment of an experienced adviser is a step backwards for our industry and ill serves our clients.