A Better Way to Measure Risk Tolerance

In building financial plans, it is critical that asset-allocation recommendations recognize the client's ability to absorb risk. To aid in this assessment, advisors often utilize risk-tolerance questionnaires, but these tools have shortcomings. The evolving field of brain science can help to design better questionnaires.

Risk tolerance can be thought of as an individual's psychological ability to deal with uncertain outcomes. Most investment companies and financial planning packages provide investor questionnaires as measurement tools. These questionnaires typically have a dozen or fewer questions. Besides risk tolerance, they also deal with aspects of risk such as financial capacity to absorb losses and investment time horizon. Given the small number of questions covering a broad subject area, these questionnaires provide only rough indications.

A more rigorous and scientific approach is provided by the FinaMetrica Risk Profiling System. FinaMetrica is both a provider of a risk-tolerance assessment tool and a research organization dedicated to the study of the subject. They have developed a 25-question profiling system, which is widely used by financial planners around the world. Unlike the simpler questionnaires I mentioned, their questions focus heavily on the individual's psychological comfort with risk.

However, even FinaMetrica’s questionnaire has been criticized and could use improvement. I will suggest improvements for evaluating and managing client risk, including an approach to risk-tolerance questionnaires that incorporates teachings from brain science.

Criticisms of questionnaires

Although risk-tolerance questionnaires are heavily used, there are significant doubts about their value. When many investors proved unable to stay on course with investments during the 2008 financial crisis, the questionnaires, including FinaMetrica’s, were criticized for not anticipating how market turmoil would cause changes in risk tolerance. FinaMetrica defended its questionnaire by showing that crisis-induced anxiety and stock-selling may have been a function of changes in perceptions about the riskiness of equity investments rather than changes in tolerance. But the FinaMetrica research was based on the FinaMetrica measurement tool, so questions still remain.

Carrie Pan and Meir Statman of Santa Clara University criticized existing risk-tolerance questionnaires in a March 2012 study . FinaMetrica views risk tolerance as a stable psychological trait, but these authors argued that risk tolerance varies with circumstances and is subject to mis-measurement because of various behavioral biases. They used results from a survey of 2,500 people to suggest improvements to questionnaires, expanding beyond risk tolerance and attempting to also measure propensities for regret, overconfidence and other investor biases.