Does Risk Tolerance Merely Track the Market?

A new risk tolerance study implies advisors can add significant value by shielding clients from the powerful influence of market sentiment

Do risk tolerance scores plummet to zero, then rise as the market recovers?

This commonly voiced suspicion in financial planning circles does not find support in a comprehensive study of risk tolerance.

But the evidence does show a link between market sentiment and changes in risk tolerance in a way that all but assures investor underperformance.

The new study, in the Journal of Financial Planning, is based on a sample of 341,782 individual risk tolerance scores covering period immediately before, during and after the global financial crisis — from January 2007 to May 2012.

Personal financial planning experts Michael Finke and Michael Guillemette combed through the data provided by risk tolerance questionnaire provider FinaMetrica, and arrived at a subtle distinction.

They found that estimates of client risk tolerance were not biased by current market conditions but observed changes in risk tolerance were broadly influenced by changing market conditions.

These estimates of risk tolerance, i.e. the questionnaires, showed stability. While the S&P 500 fell 51.70% from low to high during the financial crisis, the monthly risk tolerance surveys fell just 7.14%.

Whereas S&P 500 values exhibited a volatile standard deviation of 17.27%, the standard deviation for risk tolerance scores was just 1.86%.

And yet, despite these very different magnitudes between risk tolerance results and S&P 500 results, we find that risk tolerance surveys and the S&P 500 have a quite high correlation (.70) and risk tolerance surveys and are even more highly correlated with the bear market (.90).

With seemingly such close tracking, how are the survey estimates so much more stable than stock market returns?

A revealing table of standard deviation broken out by year provides a clue. As the market recovery took root, and stock values swung less wildly — S&P 500 standard deviation fell from 15.86% in 2008 to 4.48% in 2010 — client risk tolerance standard deviations little changed between those same years (1.60% and 1.55% respectively).

So, as the economic recovery proceeded, scarred investors revised attitudes quite slowly.

“When the stock market is falling, average monthly investor risk tolerance scores are strongly correlated with changes in the S&P 500,” the authors write. “However, when stock prices start to rise, changes in average risk tolerance seem to be largely uncorrelated with the market. 

The implication for financial planners is that investors seem to be willing to take market risk precisely when valuations become less favorable — when price-to-earnings ratios are high and dividend yields low.

The authors suggest this tendency found in risk tolerance questionnaires as a source for the short-term market volatility and long-term mean reversion in stock prices that has been theorized in academic finance studies.

In real-world terms, investors lose 1.56% in average annual returns as a result of this sentiment cycle.

So while market movements “are not likely to bias client risk tolerance scores,” the personal financial planning experts say their appetite for risk will vary through market cycles, influencing them to seek safety after periods of market declines.

The authors’ conclusion:

“Employing a long-run strategy that reduces the temptation to buy high and sell low can be a significant source of value provided by a financial planner.”

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