Too often, these questionnaires measure the wrong things.
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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?
3. It focuses only on risk tolerance. You don't want the client's risk assessment to be skewed by other factors, such as age. Otherwise, a timid 30-year-old could end up with a stock-heavy portfolio just because they have a long investment time horizon, while an older, but very wealthy client could be placed into an ultraconservative portfolio.
Assessments That Meet the Criteria
Two university professors, John Grable of Kansas State University and Ruth Lytton of Virginia Tech, have conducted extensive research into risk-tolerance questionnaires. They determined that the ones used by many financial advisors were not giving accurate estimates of a client's risk tolerance. As a result, they have developed a risk-tolerance questionnaire that attempts to live up to researchers' standards by being both valid and reliable, to ensure accurate measurements.
Their survey consists of 13 questions that assess risk tolerance. They are fairly specific situational questions that are easy to understand. At the end of the survey, there are seven additional demographic questions, which are not factored into the survey. This section allows them to identify certain general trends, such as the fact that people with higher levels of income, education and knowledge of personal finance tend to have more risk tolerance. Time horizon also factors into a person's comfort with risk, but gender does not play much of a role (surprisingly, women tend to have a slightly higher tolerance for risk than men).
I Can Afford the Risk, but Do I Want It?
Another risk-tolerance questionnaire that meets the "good" test criteria was developed by FinaMetrica, one of the leaders in the field of risk assessments. Its risk-tolerance questionnaire identifies three different risk parameters. Two are financial risks--risk required (how much risk you need to take) and risk capacity (how much risk you can afford to take)--and one is a psychological risk--risk tolerance (how much risk you prefer to take). FinaMetrica's risk-tolerance questionnaire includes 25 plain English questions that were developed to address these three aspects of risk, and the test was developed and is evaluated using psychometrics, a psychological discipline used to develop questionnaires that reliably measure something.
FinaMetrica's Risk Profile Report provides the client with a risk tolerance score that is displayed on a bell curve. The client can see how they compare with others who have taken the test, based on a "norms" database developed from a sample size of 20,000 tests. The report itself does not correlate the client's score to any recommended asset allocation percentages. However, FinaMetrica has a sophisticated "linking spreadsheet," which is a tool for the advisor to incorporate the client's risk tolerance score into the process of selecting an investment strategy.
The cofounder of FinaMetrica, Geoff Davey, spoke in January at the AICPA Advanced Personal Financial Planning Conference. He indicated that clients value the experience of taking this test and that it facilitates an in-depth understanding of their risk profile. He also maintains that the resulting report provides a "robust, defensible assessment of risk tolerance."
Is Professional Responsibility a Liability?
So, if we have a professional, legal and ethical obligation to form an opinion concerning our clients' risk tolerance, how do we demonstrate we have done that? And do we have a legal liability if we get it wrong?
Some securities attorneys caution us not to have a risk-tolerance questionnaire in our file if it indicates that the client has a different risk tolerance than the portfolio that we have designed for them. Since there is a fairly broad range for what is considered a "conservative" or "moderate" portfolio, this would only become an issue if there is a substantial difference in the risk-tolerance questionnaire results and the actual portfolio allocation. This can be addressed by documenting the reasons for a difference and having a client sign off on the decision.
It's a shame to ignore risk-tolerance questionnaires purely for liability reasons, as it can be a valuable tool when used in conjunction with the interview process. The way that a client responds to the questions in the risk-tolerance questionnaire can actually provide the advisor with meaningful information. For instance, both the FinaMetrica and the Grable/Lytton risk-tolerance questionnaires ask "When you think of the word 'risk' in a financial context, which of the following words comes to mind first?" The answer choices are "danger," "uncertainty," "opportunity," and "thrill." This leads you toward the psychological mindset of the client, which is very important to know in identifying their risk tolerance.
To Test or Not to Test
Your clients will place a high value on having a conversation about risk tolerance, especially now after the volatility of the past few years. You can use the risk-tolerance questionnaire questions to direct a conversation about their emotional risk tolerance and how it relates to their risk capacity and the risk required for them to meet their financial goals.
The following guidelines for the use of the risk-tolerance questionnaire should keep you out of trouble:
* Use a questionnaire that meets the three-criteria test.
* Use the questionnaire as one component of your risk-assessment process and not as a stand-alone.
* Document the reason for recommending a portfolio that has risk characteristics outside of the tolerance indicated by the questionnaire and have the client sign off on it.
Above all, remember that questionnaires, like any other tool, should be used to enhance our professional judgment, not replace it.
This article was cowritten by Sandra Atkins, CPA/PFS, a wealth advisor with Focus Wealth Management.