10 Myths About Risk Tolerance and How to Accurately Measure It

The Reality

Independent studies show that advisors' assessments of their clients' risk tolerance are highly inaccurate. Strong evidence exists of gender stereotyping–advisors often overestimate the risk tolerance of male clients and underestimate the risk tolerance of female clients. Advisors in general also assign too much diagnostic value to other demographic variables such as income, wealth, cultural differences and marital status.

Adding in the fact that advisors are significantly more risk tolerant than their clients only increases the likelihood of their client's over-exposure to risk. Studies show that advisors' estimates of their clients' risk tolerance correlate at about 0.4, which means that there are gross errors, two or more standard deviations, in one in six cases. Put another way, advisors would be more accurate if they made no attempt to assess clients' risk tolerance and simply assumed everyone was average. This illustrates the need for objective, psychometric testing of risk tolerance.

Myth 6

Risk tolerance and risk capacity can be assessed together in the planning process.

The Reality

Too often, advisors fail to separate out risk factors, that is, their client's tolerance for risk, their risk capacity or capacity for loss and how much risk they need to achieve their goals (risk required). It is crucial to separate out these risk factors so that portfolio recommendations can properly align all three during the risk profiling process.

As the expert financial planning commentator Michael Kitces says in his blog, "Separating risk-tolerance from risk capacity—just because you can afford to take risk doesn't mean you should," each risk factor needs to be assessed and considered separately.

Risk capacity questions such as "How much could your investment go down by without it significantly affecting your financial well-being?" should be assessed separately from risk tolerance. Risk capacity, like risk required, is a financial trait, different from risk tolerance, which is a psychological trait. Different factors impact each and they therefore need to be assessed separately.

As Kitces writes: "The financial questions—which might be related to their need to tap the assets for income/withdrawals, the time horizon of the goal and the availability of other assets—speak to the person's risk capacity," not their risk tolerance.

"Once separating out the purely financial matters, true risk tolerance becomes purely focused on a client's actual attitudes about risk. In other words, does the client actually have the mental inclination and desire to pursue a more favourable outcome at the risk of a less favourable result. Notably, these mental attitudes about risk have nothing to do with the ability to afford the risk—it's simply about the desire to pursue actions or goals that entail risky trade-offs (or not)."

Myth 7

A related myth is that questions on the time horizon of the investment, the investor's age and when the investor will retire are relevant to determine an investor's risk tolerance.

The Reality

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

Questions referring to past investment behaviour, experience, financial knowledge or time horizon, for example, are commonly mistakenly included in risk tolerance tests. However, including such questions in a risk tolerance test would distort its measure. Although time horizon, for example, might be relevant to the measurement of risk capacity or risk required, it is not relevant to risk tolerance, which is an enduring psychological trait.

Myth 8

Risk tolerance is the primary, if not sole, driver of risk behavior.

The Reality

Many different factors influence an investor's behavior such as their risk tolerance, their financial goals and their perceptions of likely outcomes. Risk behavior can change significantly with market cycles.

When investment markets are booming, for example, people tend to underestimate the level of financial risk or perceive risk to be low. In contrast, in bottoming markets, risk perception is typically at its highest and some investors, out of fear of losses, sell their shares in favour of cash, as many investors did during the global financial crisis. What changes with the market cycle is a person's perception of risk, which drives a change in behaviour, rather than their risk tolerance.

Many advisors think risk tolerance changes with major events such as a share market correction (Myth 1), but it doesn't. Typically, it is an investor's risk perception that changes, driving a change in their risk taking behaviour if share prices suddenly drop.

Myth 9

It's okay to ask couples to complete a risk questionnaire jointly, rather than each doing their own.

The Reality

When it comes to investing, women are generally less tolerant of financial risk than men. According to FinaMetrica data, in 67% of U.S. couples, men have a higher tolerance for financial risk than their female partners. Where there is a material difference in their risk tolerance levels, in 83% of cases it is the man who is the risk taker.

This is slightly higher than risk tolerance levels reported for male partners in the U.K., where, according to FinaMetrica data, in 64% of couples men have a higher tolerance for financial risk than their female partners. Where there is a material difference in their risk tolerance levels, in 87% of cases it is the man who is the risk taker.

In Australia, in 65% of Australian couples, men have a higher tolerance for financial risk than their female partners. Where there is a material difference in their risk tolerance levels, in 82% of cases it is the man who is the risk taker.

The main point is that financial advisors must not ignore the needs of the less risk-tolerant partner, who is in most instances the woman. Financial advisors often skip the process of separately assessing a couple's risk tolerance and apply the man's risk tolerance in determining a financial plan or superimpose their own preferences on the couple, which is a dangerous and unethical practice.

Myth 10

As long as I'm using a risk tolerance questionnaire, I'll be okay. I'm doing my duty and meeting compliance.

The Reality

Advisors are responsible for the processes and tools used in formulating advice. This responsibility cannot be delegated to a third party. Advisors must satisfy themselves that, at a minimum, any tool used is both fit for purpose and true to label.

The Financial Conduct Authority (in the U.K.), for example, makes advisors responsible for evaluating the tools that they use. Advisors must therefore conduct due diligence on any test they use to endure that it is accurate and reliable. FinaMetrica has developed a detailed due diligence questionnaire which can help advisors conduct due diligence process and choose a risk tolerance test.