How to better understand your risk tolerance

Source: MARKETWATCH

By Robert Powell, MarketWatch

Last Update: 12:01 AM ET May 23, 2012

BOSTON (MarketWatch)Somewhere along the way, your adviser or brokerage firm asked you to fill out whats called a risk-tolerance questionnaire, presumably before you invested a dime in this or that bond, ETF, mutual fund or stock such as, say, Facebook.

And no doubt you filled it out without giving much thought to it. Likely, your broker or brokerage hasnt given much thought to the answers on your risk-tolerance questionnaire, either.

Given that, many are starting to ask questions about a questionnaire that seems to be the appendixthe useless organof the investment world: Whats the point of these seemingly pointless risk-tolerance questionnaires? Do these questionnaires serve no purpose other than to provide cover and defense for firms and advisers in courtrooms and arbitration hearings? If there is a higher purpose, what is it? Is it even possible to build a good risk-tolerance questionnaire?

Now, by way of background, the academics say there are at least two ways looking at risk-tolerance. One textbook on the subject, National Underwriters Tools & Techniques of Investment Planning, suggests that a persons willingness to accept risk is a function of a number of factors, including willingness to undertake risk, ability to take risk, and investment time horizon.

Risk tolerance can also be interpreted in terms of a persons utility function, utility being the satisfaction one gets consuming goods and services and the satisfaction that comes with wealth.

No matter how you look at risk tolerance, academics and others say its time to build a better mousetrap, one based on science and research. I think that all these questionnaires are worthless and may be counterproductive, said Zvi Bodie, a professor at Boston University and co-author of Risk Less and Prosper.

Most risk-tolerance surveys contain questions that are not explicitly grounded in theory, according to Sherman Hanna, a professor at Ohio State University and co-author (along with Michael Finke, a professor at Texas Tech University, and Michael Guillemette, a doctoral candidate at Texas Tech University) of a soon-to-be published book on the subject, Portfolio Theory and Management.

According to the experts, one big problem with risk-tolerance questionnaires is this: They tend to focus more on a persons time horizon and less on persons willingness or ability to take risk. So, the longer your investment horizon, the greater your tolerance for risk will be and the more youll be investing in stocks. And thats a terrible way to build a portfolio.

All of the (risk-tolerance questionnaires) I have seen ask about time horizon, said Bodie. If an individual has a long time horizon, it is taken as an indicator of tolerance for risk. The possibility of having a long time horizon and yet being extremely averse to risk is ruled out.

Try this experiment

Want more evidence of this? Bodie suggested that you conduct this experiment as a way to test out his point of view: Try any of the online risk-tolerance questionnaires. Answer every question in the most risk averse way you can, but indicate that you have a long-time horizon.

We know from investment science and common sense that the appropriate portfolio should be the one that most closely immunizes the stated goalfor example, retirement income provision. In other words, it should be I Bonds and a TIPS ladder, or at least a TIPS mutual fund. That has never been the result I have gotten. Nonetheless, investment advisers will continue to use these questionnaires to protect themselves against law suits and regulatory penalties based on junk science.

Think of this way. Your ability to take risk is entirely different from how you feel about risk, Bodie wrote in his book. Risk capacity is an objective measure that reflects how much money you can afford to lose, even in a worst case, without impairing your minimal goals. But how you feel about risk is subjective.

A better mousetrap

To be fair, some academics say that risk-tolerance questionnaires are valid. The literature on risk tolerance overwhelmingly justifies the use of questionnaires based on validity and reliability or psychometric testing, wrote Guillemette, Finke, and John Gilliam, an assistant professor at Texas Tech University in a recent article in the Journal of Financial Planning.

Read their paper, Risk Tolerance Questions to Best Determine Client Portfolio Allocation Preferences

However, Guillemette, Finke, and Gilliam said in their paper that its probably better to use risk-tolerance questions based on loss aversion and self-assessment when building a portfolio than other measures.

Why loss aversion? Finke outlined it this way in an email: The way a financial planner thinks about risk tolerance may differ from the original concept that originates in neoclassical economic theory. Theoretically, risk tolerance is the willingness to accept variation in spending.

So, for instance, if you are given a million dollars and asked to plan your annual spending, you would prefer to spend about the same each year, Finke said. Spending more in some years and less in others only makes sense if we expect a bonus for being more flexible. This is the essence of asset pricingin order to get people to accept some uncertainty in future spending or return on an investment, you need to lure them with the prospects of higher expected return.

Risk-tolerant investors are willing to take the risk of living a little worse in the future if there is also the possibility that they could live a little better, said Finke. This is why economists often ask questions like Would you prefer a certain income of $50,000 for the rest of your life or a 50% chance of earning $70,000 and a 50% change of earning $40,000? in experiments to determine risk tolerance.

Finke, in his research, has found this to be a pretty lousy predictor of anything a financial planner would care about such as portfolio preference or the likelihood the household will shift assets to safety during a bear market.

What really seems to be a good predictor of behavior are questions that identify a resistance toward loss, which is more consistent with behavioral economic theory, Finke said. According to prospect theory, we tend to care more about losses than we do about gains. Questions that measure loss aversion seem to be very good at predicting actual investment behavior. Individual investors seem to do a very bad job of timing the marketthey tend to pour money into stocks when prices are high and pull money out when prices are low.

So, if a questionnaire could reveal which person will shift all their assets into cash in a bear market, it could do a better job of constructing an investment policy for a loss-averse investor.

Of note, Hanna, Finke, and William Waller, a graduate student at University of North Carolina at Chapel Hill have co-authored another paper on the subject as well.

Read The Concept of Risk Tolerance in Personal Financial Planning.

Bodie recommends another way construct a portfolio. Instead of using a risk-tolerance questionnaire, he says investors look at objective circumstances and rely on valid investment principles. For instance, in his book, Risk Less and Prosper, he recommends the practice of matching assets to ones liabilities, and then investing in risky assets. And how much risk to take depends on two considerations. One, if youve done a good job of matching your assets to your liabilities you can take on much more risk. And two, you should take on more or less risk based on your personal risk profile. In general, the safer and more flexible your human capital, the more risk you can objectively bear.

Others agree. Financial planners should carefully consider the objective situation of each client when making investment recommendations, rather than relying on some composite measure of risk tolerance that is not linked to portfolio theory, Hanna, Finke and Waller wrote in their study.

Example of risk-tolerance questionnaire

William Droms of Droms Strauss Advisors developed the below questionnaire, The Global Portfolio Allocation Scoring System, to categorize investors into risk-tolerance categories in order to develop an investment policy statement. To be fair, Droms has said his risk-tolerance questionnaire is only a starting point in understanding an investor, a step toward developing an appropriate investment policy statement.

The Global Portfolio Allocation Scoring System is used to determine an investors risk-tolerance score:

  1. Earning a high long-term total return that will allow my capital to grow faster than the inflation rate is one of my most important investment objectives.
  2. I would like an investment that provides me with an opportunity to defer taxation of capital gains to future years.
  3. I do not require a high level of current income from my investments.
  4. I am willing to tolerate some sharp down swings in the return on my investments in order to seek a potentially higher return than would normally be expected from more stable investments.
  5. I am willing to risk a short-term loss in return for a potentially higher long-run rate of return.

Respondents can choose from a five-point Likert scale ranging from strongly agree to strongly disagree. The score, combined with a time horizon, provides advisors with a starting point for portfolio allocation recommendations, including a breakdown of recommended asset class percentages. It has not been tested for validity and reliability, according to Finkes study.

Robert Powell is editor of Retirement Weekly, published by MarketWatch. Follow his tweets here.

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