Testing Risk Tolerance

Testing Risk Tolerance

A protracted market meltdown is reviving the argument against risk-tolerance tools.

So far this year the stock market has been a relentless ride of unnerving drops and sudden rebounds. Anxious clients are calling. You remind them that you have both agreed to a plan based on their risk tolerance and goals. That equation is behind their portfolio allocations and as long as they stick to the plan, they will end up where they need to be. But the more the ground falls out from under them, the more doubt may begin to creep in: Just how accurate was that risk-tolerance profile?  

Assessing client risk tolerance is standard procedure. Broker/dealers are required by FINRA rules to assess risk tolerance as part of its suitability standard for evaluating investments. Registered investment advisers must assess risk tolerance as part of the “duty of care” fiduciary obligations.  

But there’s no broad agreement on the best way to do that or how to integrate a client’s attitudes about risk into portfolios. A wide array of tools are available that can measure risk tolerance, but it’s just as important to assess a client’s financial capacity for risk—and how much, or little, risk is necessary to meet retirement goals.

“What you really don’t want is surprise when the market crashes, because that tends to increase a person’s emotional response,” says Kendrick Wakeman, CEO and founder of FinMason, which offers a free risk-tolerance tool to consumers. “Many advisors see it as a check-the-box compliance step, but it’s a great opportunity to really roll up your sleeves, sit down with the client and discuss what risk and return really means—here are the choices, and here is what a crash would look like. Unfortunately, the way we do it now isn’t conducive to that—it’s usually a risk-tolerance questionnaire that doesn’t really explain risk-and-reward to the client.”

The number of risk-tolerance tools available to advisors has exploded in recent years. Finametrica, launched in 1998, is the pioneer in the psychological assessment field; in the last few years, it has been joined by newer players such as Riskalyze and Pocket Risk.

On the consumer side, FinMason’s online tool illustrates how much a portfolio can drop in a market crash. It asks a few basic questions about expected retirement date, desired income, Social Security, current savings and future account contributions. Out pops a couple of portfolio options with risk/reward outcomes spelled out, and with them the odds of meeting retirement goals.

Finametrica doesn’t gauge attitudes about the market directly; instead, it uses questions that probe a client’s attitudes, values and experiences related to investing. For example: “Investments can go up or down in value and experts often say you should be prepared to weather a downturn. By how much could the total value of all your investments go down before you would begin to feel uncomfortable?”

Risk-tolerance assessments have their critics. One is that risk tolerance isn’t a fixed state immune to the market conditions in which it is measured. “When the market hits an all-time high, we think we can take a lot of risk, and we’ll feel the opposite way when markets are falling,” says Allan Roth, founder of fee-only planning firm Wealth Logic, LLC.  

Finametrica refutes that contention. In 2012, it published a research paper arguing that worries about the inadequacy of risk-tolerance measurement are driven by myths about the causes of behavioral change, and by advisors who refuse to accept responsibility when they have exposed clients to unsuitable risks.

The company’s own test data from 1999 through 2011 show investors’ tolerance for risk changes very little through sharp market drops, including the crash of 2008–2009. Independent researchers have drawn similar conclusions from the same data. Importantly, they tease out a difference between risk tolerance and risk “perception”—that is, between how an investor evaluates the riskiness of an investment and how that investment aligns with their risk tolerance.

“The goal is to keep the client in the market through good and bad times, so they can meet their goals,” says Tyler Nunnally, U.S. strategist for Finametrica. “You want to construct a portfolio that meets the client’s needs, but at same time, be able to stick with the plan from an emotional standpoint.”

Financial and Emotional Capacity

Wakeman splits the question in half. “Overall risk capacity is made up of two things—financial capacity for risk and emotional capacity for risk,” he says. “Each one can change independent of the other.”

For example, a change in financial capacity could stem from a shortening of the investor’s time horizon (older and closer to retirement) or from a fundamental change in her financial situation—a big financial setback or windfall, or an unexpected illness or disability.

Emotional capacity can change, he says, due to what behavioral economists see as “recency bias.”

“People project recent trends into the future,” he says. “So, when markets are rising, people tend to take more risk with their portfolios. When markets are declining, people tend to take less risk with their portfolios. It is unclear to us if recency bias acts on risk tolerance by lowering people’s desire to take risk, or increasing their assessment of the risk of an investment—but either way, there is a strongly documented aversion to risk in down markets that hurts a lot of investors in the long run.”

Roth worries about the questions posed in risk-assessment tools. “One that I tested out for myself asked a very good question: What did I do in 2008 and 2009 when the market plunged? I truthfully answered that I bought more stocks—and the test concluded that I should be 70 percent in equities, when I actually am at 40 percent.”

But Roth’s larger critique is that they don’t ask questions that measure a client’s need to take risk. “Just because someone has tolerance for risk, that doesn’t mean they need to take risk,” he says.

“I used to think these tests were worthless, but now I think they are worse than worthless—they are dangerous,” he adds.

A better approach, Roth thinks, is to set a retirement goal and then construct a portfolio that reaches the target with as little risk as possible. “Especially when the client is wealthy, we build a lifestyle portfolio of fixed-income U.S. government debt, and the rest is invested for the client’s heirs,” he says.

Target retirement age is another key issue. Capacity for risk declines as a client gets closer to retirement; most portfolio strategists advocate reducing equity exposure with age—a fundamental component of target date funds.

Yet data from Finametrica’s 900,000 completed risk assessments show very little difference in risk tolerance by age groups. Tolerance scores of 30-year-olds are nearly identical to those of 45-year-olds; 60-year-old investors are somewhat more cautious, but not to a significant degree.

Driving a 60-year-old’s portfolio construction strictly by a risk-tolerance assessment would have left her exposed to painful losses in the 2008–2009 crash.

Indeed, Roth thinks advisers should gauge risk tolerance by simply going back to the client’s account statements from 2008 and 2009 to see how that person behaved. Clients who panicked and sold in those years should probably be in conservative allocations now. “In client interviews, I ask people what they did during that period,” he says. Many admit to cutting their losses and getting out of the market. But “sometimes the answer I get is ‘I stayed the course and didn’t sell,’ although you later find out that they actually did.”

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