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A client recently refused to complete my risk tolerance questionnaire. After looking through our instrument, with its fairly standard hypotheticals about market movements and portfolio returns, they said, “That’s not how I think about risk.”
You call that risk?
The day I made my first million-dollar bond trade, I called my mom after work because I was excited to tell her about it.
“Your job terrifies me,” she said.
This made me laugh. My mother is a retired research chemist. She once told me that when pouring something into solution which had the potential to explode, she would put her other arm behind her back, so that she only risked losing one hand. Yikes!
She said this as calmly and matter-of-factly as she answered my questions about why egg whites do what they do when you beat them. She gave “You’re denaturing the protein” the same intonation as “So that you only lose one hand.”
Had I utterly botched that bond trade, we might have had an expensive trade error. Possibly, my boss would have filed a claim with his errors and omissions insurance and fired me. But the client would have been “made whole,” meaning, restored to the positions he should have had without my goof. Moreover, everyone would still have the same number of extremities.
Generally, I would say my mother is more risk-averse than I am, but clearly our definition of risk differs greatly.
What Is risk tolerance?
Investors also perceive and tolerate risk very differently, often unrelated to their ability to withstand a financial loss. Imagine two clients: Sally and Sandra, both 45 years old, single, with no kids, both earning $75,000 per year and living within their means.
Suppose Sally has $200 to her name but is perfectly comfortable plopping it all down on double zero on a roulette table. She is highly risk-tolerant, but her ability to take risk is low. Meanwhile, Sandra has inherited a $2 million investment portfolio, which she keeps entirely in cash because she’s terrified of the stock market. She has very low risk tolerance, despite her financial ability to weather an investment downturn.
If one combines ability to take risk with willingness to do so in one measurement, Sally and Sandra might both score a fairly meaningless “Moderate,” but clearly they are not the same. Sally has a high willingness to take risk, but a low capacity to do so. Sandra is the opposite. In both cases, further discussion and client education is necessary to arrive at an asset allocation which is appropriate to the clients’ goals, timeline, resources and personality.
Here is where our job gets interesting. The risk tolerance questionnaire is the start of a conversation, not the final word on how we invest client portfolios. Sally and Sandra provide one example why not.
Often, clients don’t entirely understand the questionnaire, or disagree with the hypotheticals. Sometimes we can encourage them to persist with the questionnaire. Other times we can’t and have to get there another way. In particular, when couples score very differently on my risk tolerance questionnaire, we need to explore how that might affect the investment of any jointly-owned assets.
Some clients score a very low risk tolerance on a questionnaire, but wave it all away in conversation: “That’s if I have to invest it. I trust you, just do what you think is best.” (Both flattering and terrifying!) Others worry about “high risk” diversified funds, but resist reducing a concentrated position in the stock that made them wealthy, “because it has been going up.”
Ultimately, our risk tolerance questionnaire helps me figure out where to begin the conversation, and how much education and encouragement clients need to create an investment program that’s suited to their plan and goals.
So why even bother?
Besides a flip answer about what might be required by your compliance department, a thorough exploration of risk tolerance is necessary for the success of your investment program. The wrong asset allocation is a great way to get clients to fire us. It’s also bad news for their goals if they can’t stomach the variance and jump out at the bottom of a market dip.
A portfolio that our risk-hating millionaire, Sandra, can afford might keep her awake at night, but talking through these issues might help her tolerate enough variance to allocate some of her inheritance towards equities. Helping our risk-loving, low-asset Sally save for near- and longer-term goals might keep her from throwing next month’s car repair funds at dogecoin – and the questionnaire might help expose a propensity to do the latter.
My questionnaire-shunning client had a well-demonstrated ability to weather a loss in their investment portfolio, and with some further discussion, we agreed to use their previous advisor’s asset allocation as a general framework. A further discussion of how they did think about risk led me to suggest swapping some funds to eliminate exposures they didn’t want and which offered more transparency than those they disliked from their previous advisor. This was an hourly project engagement, so I don’t know what the portfolio looks like today, but I’d be willing to bet that it’s not what a standard web questionnaire would recommend.
Suzanne Highet, CFA, CFP®, is a financial advisor at Core Planning and an independent investment consultant. She is based in Portland, Oregon, and serves individual clients and RIAs around the country.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
