It’s every planner’s nightmare: clients who panic and sell at the bottom of the stock market and then tell friends how much they lost on your watch.
Judging risk tolerance accurately is essential for both advisors and their clients. Although planners can provide information and change a client’s perception of risk, once a client has the facts, planners can’t alter how a client feels about the pros and cons of risk vs. reward. In short, says Geoff Davey, cofounder of FinaMetrica, the Sydney, Australia-based risk tolerance profiling firm: “You can’t educate somebody to be more risk tolerant.”
Yet many advisors think they can, he told Financial Planning. They also believe they can estimate a client’s risk tolerance through interviews. But they go badly astray in one of six cases, according to Davey: “They’ll be off by two clothing sizes, by analogy; they’ll think a client is a ‘medium’ when he’s really an ‘extra-large.’”
Since education is a different issue, FinaMetrica’s test for risk tolerance assumes that clients understand financial principles only slightly better than does the “man on the street.”
Most planners give clients questionnaires to fill out, but these often include questions about goals and time horizon that confuse the picture. In a 2005 study, Douglas Rice at Golden Gate University gathered more than 130 industry questionnaires on risk and answered them as conservatively as he could, or as aggressively. The most conservative answers generated recommendations of anywhere from zero to 70% stock holdings in a portfolio. The most aggressive answers yielded recommendations of 50-100% stock. Those large ranges, Davey explains, expose that the questionnaires aren’t measuring risk tolerance. “It wasn’t your answers that mattered, it was which questionnaire you used,” Davey said.
Less than 5% of American planners use FinaMetrica’s test, which, Davey said, meets standards for validity and reliability. Barclays Bank also has a scientific test that assesses financial personality, rather than simply risk tolerance. (A valid test answers the question it has been designed to test; a reliable one does so repeatedly.) The other questionnaires available may be assessing something other than risk tolerance or frequently get the conclusion wrong.
In the United Kingdom, regulations have tightened up how planners assess risk tolerance, and most use scientifically valid profiling systems like FinaMetrica’s. Davey expects that within five years, U.S. law will address the point as well, requiring a “robust approach.”
FinaMetrica’s test takes about 15 minutes to complete. It provides both a score and a classification, placing the test-taker into one of seven categories. About 400,000 people have taken it.. Although risk tolerance is a personality trait set by the age of 22, it gradually decreases with age and can change after major life events such as a marriage, divorce or bankruptcy. The company recommends asking clients to take the test at least every three years.
As too many people discovered in recent years, the cost of panicking in a downturn is significant. According to a study by Russell Investments, for example, investors who had $100,000 at the market peak in September 2007 in a balanced portfolio would have ended 2010 with nearly $103,000, if they didn’t sell. If they panicked and sold in September, 2008, around the time Lehman Brothers went bankrupt, they would have ended 2010 with $86, 140.