If you’ve engaged a financial adviser to provide investment advice, you’ll be familiar with risk tolerance questionnaires. These questionnaires ask you a series of questions that try to help your adviser identify your tolerance for investment volatility.
Robo-advice services also use questionnaires as a primary source of information to determine an appropriate asset allocation for its users.
I want to share a dirty little secret about risk tolerance questionnaires.
I don’t think they’re nearly as valuable as most people think.
Risk tolerance is only one aspect that is relevant to your risk profile
Risk tolerance relates to your psychological or emotional ability to handle the ups and downs of the market.
However, this isn’t the only factor that determines your risk profile. Other factors include:
- Your capacity to deal with risk. This can be determined objectively. Someone on a limited income who is nearing retirement has far less capacity to spring back from a downturn than a young person on a healthy income with their career ahead of them.
- The risk needed to achieve your objectives. For example, someone who has achieved all of their financial goals might be in a position to take on less risk than they might be able to stomach, simply because there isn’t any need to take on this risk.
Answering a questionnaire is nothing like experiencing something
You can describe sex to a virgin, but you’ll never capture the experience.
Most experienced investment advisers will tell you that the only way of knowing a client’s risk tolerance is by seeing how they respond to a major downturn.
A questionnaire might indicate how you’ll respond when your investments drop 15%, but the only way to really know is when it happens.
This blog is made possible by Fairhaven Wealth, my independent, fixed-fee, advice-only financial advice business.
Risk questionnaires don’t influence advice that much
In a former life I used to review a lot of financial advice prepared by a lot of advisers, often for the purpose of assessing whether there was a reasonable basis for the advice.
It got to the point where I barely paid any attention to the risk tolerance questionnaire responses. I would just look at the age, occupation, income, and asset position of a given client and predict what the recommended investment allocation for the client would be.
I only needed to look more deeply if there was a significant departure. In most cases the outlier wasn’t because of risk tolerance but something more mundane like short-term cash flow needs (eg buying a house, anticipating significant renovations).
“The Risk Rorschach”
Risk tolerance questionnaires can be Rorschach tests for advisers. My experience is that responses for any given adviser’s clients tends to cluster in a similar way.
In other words, it often reveals as much about the adviser as it does the clients: the way they ask questions; lead responses; interpret what the client says; etc. It’s an area they can manipulate (consciously or unconsciously) to help rationalise the advice they want to provide.
What does the risk tolerance of a trustee matter?
There’s some debate between trust practitioners, but I share the view with many that a risk tolerance questionnaires are especially irrelevant for trusts, especially where a professional trustee is involved.
Ultimately, what does it matter how the professional trustee feels about risk? The focus should be the objectives of the trust and acting in the best interests of its beneficiaries.
The settlors have alienated their interest in trust assets, so what should their risk profile matter? (Even if they’re co-trustees, they are acting in their capacity as a trustee, not their personal capacity, so their personal risk tolerance should be less relevant.)
If a trust is held for the benefit of a number of different beneficiaries, should you consider the tolerance for risk of all beneficiaries? How do you weight the different views?
Needs, objectives, and capacity are more important.
Questionnaires are still valuable!
Despite my scepticism, I still go through the questions with clients. The purpose of this article isn’t to say that risk tolerance questionnaires should be ignored – just that they shouldn’t be relied on entirely.
They’re still useful:
- From a pragmatic perspective, there are some compliance or risk-averse people, potentially even regulators or dispute resolution schemes managers, who are dogmatic and are attached to the importance of risk tolerance questionnaires. We need to choose our battles.
- It is a great way to build rapport with clients. Asking someone questions about risk sounds boring, but once you start getting into it starts getting really interesting – similar to how ethics seems boring, but gets really interesting when you start getting into issues like when it is acceptable to lie; trolley problems; and the like.
- Running through various scenarios and asking clients how they would respond not only gives you a context for getting to know your clients, but it also creates a context for educating them, and explaining how investments work. It’s a good way to manage client expectations, and make them more comfortable for the inevitable times when investments underperform and the inherent uncertainty with investing and life in general.