Investors' stated risk tolerances tend to be higher than those implied by the portfolios either they or their financial advisors construct, according to an analysis recently published by the Certified Financial Planner Board of Standards' Financial Planning Review.
The headline finding of the new paper suggests that advisors are systemically investing their clients' assets more conservatively than would be implied by their stated risk tolerance. According to the paper's authors, this conclusion pushes back against the suggestion that financial advisors are prone to exposing their clients to excess or undue risk. In fact, the opposite appears to be true — and that may itself be a problem.
The authors of the analysis include John Thompson of the University of British Columbia; Longlong Feng of Western University in London, Ontario; Adam Metzler and R. Mark Reesor of Wilfrid Laurier University; and Chuck Grace of the Ivey Business School.
According to the researchers, the systematic under-risking of portfolios implies a potential "efficiency cost" ultimately borne by individual investors and by society at large. Given the increased degree of responsibility that individual workers now bear with respect to providing for their own retirement security, the analysis posits that many investors may not be taking as much investment risk as they reasonably could.
This means, in turn, that many investors may have to rely further on social insurance programs and other sources of support.
The authors conclude that the financial advisor community could be better off utilizing a statistical concept they refer to as "value-at-risk" to more accurately measure what the authors refer to as "elicited risk" and "revealed risk." This approach allows advisors to accurately identify the discrepancy between stated risk tolerances and actual risk-taking, the authors claim, thereby providing a roadmap for determining whether clients are over-risked or under-risked.
The Limits of Risk Questionnaires
As the paper authors note, financial advisors commonly use questionnaires and discussions with clients to determine investment goals, elicit risk preferences and establish a suitable portfolio allocation for different risk categories. At the same time, financial institutions generally assign risk ratings to their financial products, and advisors use these ratings to categorize products into the various risk categories used for portfolio allocation.
"This information, obtained through questionnaires and client-advisor discussions, includes demographics, financial goals, and risk preference and tolerance attributes," the paper states. "Using know-your-client information, advisors establish a suitable distribution of wealth across broad risk categories."
According to the researchers, it is important to note that the initial risk assessment phase does not represent the development of an actual portfolio construction strategy, since it does not address specific products or asset classes. They call this initial risk analysis the client's "elicited risk."
The next step is for advisors, armed with the elicited risk preference and the risk classification of financial products, to actually help their clients select and maintain a portfolio of real-world assets. The researchers call the selected portfolio's risk "revealed risk," and as noted, this second measure is routinely different from elicited risk.
