Since many financial advisors tend to think their interview skills and experience are all they need to judge clients' risk tolerance, few are inclined to use formal assessment tools. As we see it, this is a mistake. Judging a client's ability to accept possible losses is very difficult to discern in an interview alone. Planners can meet regulatory guidelines, avoid angry clients and lawsuits, and serve all their clients more effectively by using scientifically tested profiling tools.
Both the SEC and FINRA require that financial advisors obtain an accurate assessment of their clients' risk tolerance, along with information about employment, yearly income, net worth and investment objectives. Of all of these, risk tolerance is the most difficult to judge.
The stakes are high. Clients may leave if the value of their investments drops below what they can accept. Those who panic and sell in downturns often make a costly error. In the worst cases, disgruntled clients could charge their financial planners with putting them in unsuitable investments or with fiduciary misconduct.
When we polled 14 planners for this article, just a third told us they use any established risk-profiling scale or questionnaire. FinaMetrica's risk-profiling tool is the best known and, in some ways, the gold standard. But only 5% of U.S. planners use it, even though the company presents it as a way to generate rich discussions between advisors and clients rather than as a substitute for those conversations.
WHY INTERVIEWS FALL SHORT
Reports reveal that planners may badly misjudge the risk tolerance of their clients. For example, a study by John E. Grable and Michael J. Roszkowski published in Financial Counseling and Planning found that using a simple logarithm or just assuming a client has average tolerance is more accurate than a typical planner's assessment. In fact, when clients judge their own risk tolerance, they are often more accurate than planners. Another report by Grable and Roszkowski published in the Journal of Behavioral Finance found that undergraduate college students could gauge clients' risk tolerance with almost the same level of accuracy as planners relying on mere casual knowledge of the clients and visual cues.
These academic studies conflict with statements we hear, such as, "The real risk tolerance assessment boils down to the advisor's professional judgment," or "An in-person interview is the most critical aspect of the risk tolerance decision and recommendation process." There is no scientific evidence to support these claims.
Research shows instead that interpersonal dynamics strongly skew what clients say in interviews. For example, in the second study by Grable and Roszkowski, men report the lowest tolerance for risk when they answer questions from a man. When filling out an electronically based questionnaire or speaking to a woman, men report more tolerance for risk. Women report higher risk tolerance when speaking to a man than when filling out a questionnaire either on paper or electronically, or when speaking to another woman. When clients see the interviewer as attractive, their risk tolerance tends to be higher.
Another study by the authors of this story, to be published soon in the Journal of Financial Therapy, found planners tend to overestimate their male clients' risk tolerance. They also underestimate the risk tolerance of their female clients.
It stands to reason that open-ended questioning is influenced by the interactions between the client and planner. The trouble is that the client may feel much differently in the months and years to come when markets rise and fall and the planner is not physically present. Planners may also vary in their judgment. A solid questionnaire ensures that you are consistent from one client to the next regardless of the day, market conditions or your mood.
One reason planners rely on interviews so heavily is that they are dissatisfied with questionnaires used in the past. "It seems that all of the questionnaires have the same or similar questions," was a typical remark. In fact, questionnaires vary quite a bit-and many now in use are far from scientific.
The most common error financial planners make is to focus solely on time horizon. True, investors with more time can assume greater portfolio volatility because they can recoup losses, but this does not necessarily mean they have the stomach for market downturns. Other red flags are questions about future purchases or inheritances. These factors are important for managing a portfolio, but they are not a measure of the client's attitude toward risk.
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 allocation recommendations of 50% to 100% in stocks. Those large ranges suggest that the questionnaires were not doing the job of placing individuals into appropriate asset allocation categories.
MEASURING RISK TOLERANCE
An important step is to separate risk tolerance from other considerations related to risk. A client's risk tolerance represents his or her willingness to make choices that bring the possibility of financial loss. This is not the same as a person's perception of risk, although perception does influence tolerance. Further, this is not the same as risk preference-the action a person prefers. Finally, there is risk capacity-a measure of the impact of a loss on the overall financial picture.
It is also essential to use a tool that has been scientifically tested for validity and reliability. A valid tool measures risk tolerance, rather than one of the other concepts listed above or something else-such as the dynamic between the planner and client.
A reliable tool provides consistent results over time and with different kinds of clients. Reliability scores can range from 0 to 1.0. A score above 0.7 is considered acceptable in the academic literature; scores above 0.90 are very rare. There are at least six tools now available that have been tested for their reliability (see "Choosing a Risk-Profiling Tool," above left).
In addition, a relatively new scientifically tested assessment tool, developed by researchers Elke Weber, Ann-Renee Blais and Nancy Betz, analyzes two aspects of risk-investing and gambling. Each aspect is measured by four items. The questions address perception and preference for risk, with each question focused on risk tolerance (rather than concepts such as time horizon or other items that should not influence risk tolerance). The scale's published reliability is about 0.88.
Financial advisors looking to add a formal questionnaire to their practice may want to consider the tools listed in the table. All are scientifically tested. Avoid any test that has just one question-risk tolerance always has more than one dimension.
It's wise to retest the risk attitude of clients periodically-at least every three years or after a major life event. Although the academic research is inconclusive, many financial planners believe risk tolerance decreases gradually with age. We do know that risk tolerance can change after major life events such as marriage, divorce or bankruptcy. It is also known that a person's willingness to take on risk can be changed by interactions with their advisor.
Regulations in the United Kingdom and Australia now require that financial planners use a standard procedure-and not rely on professional opinion alone-to assess risk tolerance in clients. In 2006, U.S. regulators published guidelines indicating the importance of risk tolerance assessment when providing retirement planning advice. Future federal regulation may demand that advisors use a valid and reliable questionnaire. Fortunately, planners can improve their performance dramatically today by using any of several tools. Even better: most of them are inexpensive or free.
Sonya L. Britt, PhD, is an assistant professor at Kansas State University and president of the newly established Financial Therapy Association. John E. Grable, PhD, is a professor at Kansas State University and co-editor of Financial Planning and Counseling Scales.