Cutting Through the Bear and Bull: Determining Your Risk Tolerance

We've all taken one at some point in our lives, that series of questions whose answers promise to accurately tell us whether we are aggressive investors, conservative investors or somewhere in between. I'm referring of course to the risk tolerance questionnaire, a tool commonly used by financial advisors worldwide. A tool whose output we largely accept without a second thought because it professes to accurately quantify what allocation is appropriate for us based on a few simple, multiple-choice questions. Recently, a friend took just such a quiz and called me afterwards to ask my thoughts on the matter. His particular quiz was quite short, only five or six questions and the results made us both rethink something we and many others have taken for granted – the accuracy of the average risk tolerance questionnaire. The basics one would expect to find in something claiming to be a risk test were in fact covered. One question dealt with his willingness to accept risk in the portfolio, another asked about his ability to do the same. A third question inquired about his knowledge and comfort level with investing in general, while the others filled in the basics like time horizon to retirement. His answers were extremely conservative as he is a cautious investor by nature. He does, however, have the ability to accept risk, given his decades to go before he expects to tap into this retirement account. He also considers himself knowledgeable as he follows the markets and took some investing courses in graduate school. The results of this quiz were surprising to both of us. Despite answering every question as conservatively as the multiple-choice answers allowed, his experience investing and long time horizon caused the quiz to brand him an aggressive investor, despite his answers and expectations. Most risk tolerance questionnaires work the same way. A series of questions are posed each of which have between three and five answers to choose from. The test taker is asked to select the answer that is most appropriate for them. Each answer corresponds to a certain number of points. When the quiz is completed the points are added up and, based on pre-determined breakpoints the client is then placed in a risk category. For example, a test that has a total of twenty-five points possible might qualify an investor as aggressive if they score an eighteen or greater. That same test may place you in the most conservative category if you score six or less points based on the questionnaire. There has been a tendency, in recent years, by financial advisors to use simpler and shorter questionnaires to determine an investor's risk tolerance. While doing so saves time, it can be far more harmful by misaligning clients and portfolios. A few extra minutes to determine the right risk tolerance can make a world of difference in terms of getting the correct portfolio volatility and returns for your individual needs. If advisors bothered to spend time with clients and understand their situations, concerns and needs rather than relying on a quantitative tool that may have been poorly constructed in the first place there may be fewer investors out there who lay awake at night worrying about their portfolio balance. Here are a few steps you can take to determine whether the risk tolerance quiz your advisor has given you is accurate. How many questions does the quiz have? Any questionnaire with fewer than ten questions should be carefully scrutinized. Anything with five or fewer questions is too basic for most investors and its result should not be the basis for a long term portfolio. Ask whether the advisor gets paid more, less or the same depending on whether you select an aggressive or a conservative portfolio. Sometimes questionnaires are skewed purposefully to gear clients towards a particular portfolio. Ask your advisor what percentage of their clients fall into each risk category. An advisor who has many more of one type of client than another might have a good reason, like focusing on a particular segment of the population, or they could have a poor risk tolerance questionnaire. Take more than one risk tolerance questionnaire. Many are available online for free, including the legend to translate your answers into a risk score. Or take the same quiz multiple times with different answers to see if it directs you to a different portfolio. The bottom line is that the average risk tolerance questionnaire often fails in terms of accuracy and is too short to be of much value to many investors so once again the onus is on the investor to determine what is best for them. About the author: Michael Prus is the President and Founder of Scale Investment Group, LLC, a registered investment advisory firm based in White Lake, Michigan The company manages money for clients and is a consumer advocate, most notably championing greater transparency of the investment advisory industry and lower fees for investment products as well as portfolio management services. Contact Michael directly at mprus@scaleinv.com.