Risk-Tolerance Questionnaires Demystified

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One of our duties as advisors is to understand our clients--their needs, their financial and personal situation, and their risk tolerance. We all profess to do this and most of us would affirm that we do get to know our clients. But how can we accurately assess our clients' risk tolerance after only a few short meetings?

How To Determine Risk-Tolerance
In order to determine an appropriate investment strategy for clients, we need to know the level of risk that they are comfortable taking. One way to identify this is by interviewing the client and asking questions about their investment knowledge, the prior experience they have had with investing, and so forth. We also consider their stage in life, how they plan to use the investments, and whether they are accumulating assets or beginning a withdrawal phase. Since many clients do not understand the relationship between asset allocation and volatility in the portfolio, we sometimes don't figure out how risk-averse they really are until the first time they experience a loss in the value of their investments.

One of the most popular ways to determine risk tolerance is to have the client complete a risk-tolerance questionnaire. You can find dozens of questionnaires on the Internet. Many are on sites of brokerage firms and consumer websites that purport to help an individual identify their risk tolerance by answering five or six questions. The answers to the questions indicate a score that magically correlates to the recommended asset allocation for the client.

This method of identifying risk seems to be a quick way for advisors to justify their recommended asset allocation in lieu of taking time to really understand the client. The question is this: How reliable are these risk assessments?

What Constitutes a Valid Questionnaire?
According to an article by Money magazine, there are three criteria for a "good" risk-tolerance questionnaire:

1. You can't fill it out in a minute. This eliminates the five to six question tests. Several of the more recognized independent tests have 13 to 25 questions, which are able to cover more aspects of risk.

2. The questions make sense. Frequently the questions are vague and don't define parameters. For instance, "I can accept minor fluctuations in my account value in exchange for more income," which is to be scored from one for "disagree" to five for "agree." How does an inexperienced investor know what percent gain or loss in a portfolio is represented by "minor fluctuations" and how much income is "more" income?