Risk Tolerance Tests Results Often Distorted

There’s no doubt that having an understanding of your client’s investment knowledge and experience is an important aspect of knowing your client. It is, however, of no relevance in assessing risk tolerance. While this understanding may influence the final advice given, investment knowledge and experience are separate factors to a person’s risk tolerance.

Asking about a person’s investment knowledge or experience in a risk tolerance questionnaire would distort the results of the risk tolerance assessment. Risk tolerance itself is an enduring psychological trait. However, questions referring to past investment behaviour, experience or financial knowledge are commonly mistakenly included in risk tolerance tests. Years ago it was not uncommon to find questions relating to physical risk tolerance in questionnaires designed to measure financial risk tolerance.

Today, the more prevalent problem is that many risk tolerance questionnaires deal with irrelevant financial matters. Indeed, industry-standard questionnaires too often have been arbitrarily constructed without regard to psychometrics. Typically, they contain too many “bad” or irrelevant questions and not enough “good” questions. As a consequence, their results are neither valid nor reliable assessments of risk tolerance.

From time to time, it is suggested that in addition to us asking risk tolerance questions, we should also ask other questions required for a fact find. However, we believe this would create more problems for our subscribers that it would solve. There are many different but quite acceptable approaches to conducting a fact find and they can involve a degree of complexity that only becomes apparent after an initial interaction with the client.

It is our view that everyone’s best interests are served if we focus purely on risk tolerance assessment and the application of risk tolerance assessments in the financial advising process.

Conducting due diligence is therefore essential in choosing an appropriate risk tolerance questionnaire. Advisors or wealth managers need to first make sure the test meets universally accepted psychometric standards and that it is valid and reliable before using the test with clients. The psychometric integrity of a risk tolerance test ensures the accurate mapping of risk tolerance scores to investment portfolios.

FinaMetrica has developed a comprehensive list of questions that can help advisors conduct due diligence on any risk tolerance test. At a minimum, advisors must satisfy themselves that, any test used is both fit for purpose and true to label.

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One thought on “Risk Tolerance Tests Results Often Distorted

  • The main flaw I see with “risk tolerance questionnaires” and the outputs -is that nowhere on there does the client’s real life needs and goals enter into the determination.

    Where the client is overly cautious in answering the questions, then the bulk of their investments will be skewed towards low risk/low return assets – bonds, treasuries & gilts -thus dooming the client investments to potentially a lifetime of lower returns and running out of cash in their lifetime.

    Clients need to be trained that there is a significant difference between volatility and risk. A temporary broad market decline of 20% does not represent a permanent capital loss of 20% – unless the client chooses to panic out.

    It is hard and demonstrable financial needs—and not “risk tolerance”—that should always be the main determinant of the asset mix.

    And yet compliance departments insist on risk tolerance questionnaires.

    Mapping funds to risk tolerance outputs doesn’t get over this issue either – client real needs versus risk tolerance outputs?.

    What is everyone else out there doing?

    Reply

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