by Maximilian Viski-Hanka
Above-average. Above-average is my “apparent” risk tolerance as determined by an investor risk tolerance quiz developed by Dr. Ruth Lytton at Virginia Tech and Dr. John Grable at the University of Georgia. This quiz is just one of many that any investor could take to have someone, or better yet, an algorithm, determine their risk tolerance. But what really is our own individual risk tolerance? How can something as abstract as a quiz or questionnaire determine what my risk tolerance really is? For example, I was labeled as having an above-average risk tolerance, yet I can’t even bet $5 on a roulette table for fear of losing that meager five dollars. This great fear of losing money, even though I have an above average risk tolerance, is common among investors throughout the world.
When creating an investor’s portfolio, financial advisors are expected to determine their client’s risk tolerance through the use of various assessments and questionnaires. However, when faced with tangible, rather than abstract losses, many investors realize that they habitually over-estimated their own risk tolerance.
These risk assessment questionnaires typically ask questions relating to individual’s behavior in bull or bear markets, years until retirement, age, income, marital status, etc. Unfortunately, these questionnaires don’t cover the full story. As Allan Roth, a Financial Planning Contributing writer and founder of the firm Wealth Logic in Colorado Springs, CO., stated, “the problem is that we are emotional beings rather than logical ones.” As the famous Jim Valvano once said, “If you laugh, you think, and you cry, that’s a full day. That’s a heck of a day.” When investors fill out these questionnaires, their confidence level, mood, atmosphere, and a whole range of other emotions can, and usually do, influence their answers. For example, on a really good day an investor may want to be very aggressive in his investments, whereas on a different day that same investor might feel risk averse due to the emotional turmoil of a death in the family. Emotions and the impact that day-to-day occurrences have on an investor’s investment objectives are highly undervalued when it comes to their risk assessment.
During the credit crises and market drop of 2008 and 2009, many investors discovered that they could not withstand the substantial drop in the market; these events made many investors incredibly risk-averse for fear of losing their livelihood. Mr. Roth, however, feels that such aversion is now a thing of the past because many investors seem to have already forgotten the 2008 crises, and because the high stock prices have instilled renewed confidence in these previously hesitant investors. But what happens if the market experiences a severe pull back? Will people deny the fact that they were risk tolerant? Why can’t questionnaires foresee these fluctuations in risk tolerance?
Several renowned financial analysts believe that questionnaires are unable to accurately determine the “behavioral facets of risk,” As two of these analysts, Brad Klontz, an associate professor in personal financial planning at Kansas State University, and Ron Sages, a wealth management advisor and personal financial planning researcher in Greenwhich, Conn., believe that questionnaires cannot cut to true willingness of a client’s ability to accept loss and risk. To rectify the problem, Mr. Klontz suggests a variety of attributes that should be taken into account when determining a client’s risk tolerance: client gender, planner gender, risk perception, risk composure, anchoring, previous financial loss, etc.
Ultimately, the goal is to figure out what can one do when trying to accurately determine their risk tolerance? In addition to Mr. Klontz’s suggested attributes, investors should thoroughly discuss their risk tolerance with their financial advisors, rather than leaving it up to a questionnaire; investors should only use these questionnaires as general indicators to determine whether any changes need to be made to their perception of risk. Most importantly, instead of determining at the first couple meetings what one’s risk tolerance might be, investors should wait and take some time to contemplate their risk profile. Accordingly, financial advisors should take the necessary steps to ensure that they get the most accurate depiction of their client’s risk tolerance. Finally, advisors should check-in on their clients throughout their time together and make sure that their investment objectives and risk tolerance have not changed. Making sure this information is accurate is crucial and beneficial to all parties involved.
To find out more please visit: Why Risk Tolerance Questionnaires Don’t Work