Advisors today have many tools for, and opinions about, assessing client risk tolerance and mapping this to a portfolio. Some use questionnaires, others license software specifically focused on risk, and some rely on conversations and their professional judgment. Despite the multitude of approaches, we should all agree on one thing: An accurate and reliable risk profile is key to investors’ outcomes and an advisor’s success.
Indeed, getting risk wrong can result in direct losses for retail investors as well as lost clients and legal and regulatory complaints for advisors.
As we've pointed out before, on average, 20% of clients leave their advisor within the first year, according to a study by Spectrem Group. The three top reasons were:
- A lack of good service and personal communications,
- A lack of understanding about the client’s overall financial goals, and
- Poor understanding of the client’s willingness to take risk.
In addition, there are new, more demanding (and expensive) regulations in the United States, Canada, and elsewhere that require advisors to demonstrate how they are acting in their clients’ best interests. At the same time, fees continue to drop for traditional investment management businesses. With a global pandemic forcing relationships to go digital, advisors are left trying to offer more-personalized service to a larger client base for less money, and the service must do a better job in “knowing your client”–ouch!
No wonder so many clients are looking elsewhere or, alternately, choosing to go it alone: According to Finder, a global financial information intermediary, over 3 million Canadians (10.1%, mostly millennials) were planning to stop using a financial advisor in 2021, with another 15% seriously considering this action.
So, why is risk profiling so hard to get right? Not all investors are advised, but why did 57% of U.S. households reduce their equity holdings in 2008 despite many advisors encouraging them to “stay the course”?
There are a couple of reasons worth highlighting. First, in advised relationships, many advisors believe that their clients’ risk tolerance drops during a downturn. Second, after a market disruption like 2008, when the five-year volatility of many investment products doubled, product risk ratings were systematically recategorized higher. If clients’ tolerance drops at the same time the riskiness of their investments increases, advisors are obliged to move clients to new “lower risk” solutions.
Stability in a Risk Profile
Everything around us seems to be in a state of continuous change, as technology keeps breaking our reality into shorter news cycles and smaller sound bites, a constant stream of real-time market updates and 140-character tweets. So, why wouldn’t our risk tolerance be as ever-changing as the headlines on our smartphones?
The reality is that our view of the world is not defined in six-hour or six-month slices. Our personality does not change with each new market update, nor do our life goals, and good financial planners know this. The aim of sound financial advice is to help consumers frame reality—not according to the daily news but according to what matters: the stories of their lives.
So, why do so many questionnaires show significant changes in a client risk profile? Not all questionnaires that claim to measure a client’s risk tolerance are created equal. Some combine multiple aspects of the client’s profile and try to score them together. Other questionnaires might use what have been called “revealed preferences” and focus on risk aversion or the point at which an investor will become overly uncomfortable, using questions framed as gambles.
Other questionnaires take a psychometric approach. The science of psychometrics is the marriage of psychology and statistics, providing standards for evaluating tests and sorting good questionnaires from bad. Through psychometrics, we can determine if a test is good: Namely, it must be both valid—measures risk tolerance as expected, and reliable—measures risk tolerance consistently over time with accuracy. A good psychometric test will employ a series of easy-to-understand questions that help determine how risk tolerant one client is relative to the rest of the population, with a high degree of reliability. Academic research points to psychometrics as being a superior way of predicting financial risk-taking.
Psychometric questionnaires have been shown to give greater insight into actual risk-taking behavior in the real world and greater test-retest stability. Said another way, a gambles-based methodology might help an advisor understand what clients will do in Las Vegas, not necessarily what they will do when they invest. Such tools might also produce a different result every time the client takes the test, which is not a stable basis on which to provide advice!
Our research at Morningstar is based on a risk-tolerance test developed by FinaMetrica. Each respondent receives a score between 1 and 100 (with a mean of 50); this is their risk tolerance relative to the population at large. The questionnaire has been taken by 2 million respondents over two decades, allowing us to see trends over time and market cycles.
The upshot from our analysis of all this data: Risk tolerance is a psychological attribute and doesn’t meaningfully shift from year to year.
We can verify how a person’s risk tolerance stays constant based on repeated test results, as respondents took the same test multiple times, sometimes a year later and sometimes five years later. They usually scored very close to previous tests.
Exhibit 1 is a scatterplot of a sampling of our findings. We graphed each subject’s risk tolerance, scaled from 0 to 100, on two different occasions. A person’s score is usually within 10 points of a prior score. So, someone with a low risk tolerance might score a 20 one time and 23 the next. Someone with a higher risk tolerance might score around 60 and then a 55 for the second test. Certainly, there is some variation among the participants, as shown by the elliptical “cloud,” yet note how the slope of the plots is around one, indicating scores were generally equal or very close to one another between the two points in time.
Exhibit 1: Distribution of Risk Tolerance in Test/Retest 
Stability in a Portfolio
So, if clients’ risk tolerance doesn’t generally change through market cycles, it follows that their properly implemented long-term investment strategies shouldn’t change either, all else being equal.
As an advisor who wants my clients to stay the course, I can do a much better job of advising them if I have both a defensible and stable measure of their risk tolerance and the same for the riskiness of the portfolio I am recommending.
To help on the portfolio front, Morningstar recently launched the new Morningstar Portfolio Risk Score anchored around the Morningstar Target Allocation Indexes for conservative to aggressive portfolios. These indexes maintain stable equity allocations regardless of how the market performs, providing a more reliable set of benchmarks (and thus a more stable rating system and reference point for portfolio risk assessment) in various market environments. For example, if the Morningstar Portfolio Risk Score shows that a client’s portfolio is well-aligned in composition to the Morningstar Moderate Target Allocation Index, it will remain so in the future provided it maintains a similar allocation.
Personalizing Advice
Having better tools to measure both client risk tolerance and portfolio risk is critical for good advice, but we also need a better mechanism for bringing the components together in order to determine a personalized long-term investment portfolio that’s appropriate for each client’s risk profile and is in the client’s best interest.
Let’s consider how portfolio assignment has been done traditionally. Exhibit 2 from the FinaMetrica risk-tolerance data set shows how investors’ risk scores are normally distributed across the population. Again, the reliability of the test has been measured across 2 million consumers and multiple investment cycles.
Exhibit 2: Distribution of Risk-Tolerance Scores 
Yet this grouping of people and product is a blunt instrument in today’s digital world where every client experience from entertainment to advertising to social media is targeted to specific interests and behavior.
Instead of saying, “Client, your risk level is a number 4, so you get our number 4 portfolio,” we propose a more personalized approach in Exhibit 3. With a completed psychometric risk-tolerance test and consideration of different investors’ expectations for risk-taking along with other factors such as time horizon, we can derive a Risk Comfort Range that would be appropriate for the client. The Risk Comfort Range allows an advisor to see a more realistic range of portfolio risk that could be applied for a given client and situation and determine a solution accordingly, as opposed to assigning a person to one of a handful of cookie-cutter profiles and investment policies.
In the example below, a portfolio is crafted to fall in between two standard investment profiles (bands), staying well inside the Risk Comfort Range but providing a more personalized portfolio than would be afforded by either the Moderately Conservative or Moderate investment profile alone.
Exhibit 3: Risk Comfort Range of 36-55 and Morningstar Portfolio Risk Score of 47 
Before people object and say, “We cannot afford or do not want our advisors to craft personalized portfolios, nor do we want to build 100 different models,” I will note that any portfolio risk level can be achieved by simply combining two standard models. In the example in Exhibit 3, we can provide the client a portfolio with a Portfolio Risk Score of 47 by combining 65% in the Moderate Conservative model and 35% in the Moderate model.
So, accurately assessing client risk tolerance and portfolio risk levels with the right methodology keeps the focus on the client and provides more-stable advice. Basic changes can provide flexibility and personalization of their investments. The technology is here to offer clients such an approach, tailor-made to their risk profile. This approach will serve as a significant differentiator for advisors in the years to come.
We invite you to dive deeper into the topic in our white paper: “Measurement of Client Risk Tolerance: How Improving Methodology Could Offer Advisors a Significant Competitive Advantage.”