Garbage in, garbage out, the saying goes.
And so finds a new behavioral finance study of investor risk tolerance questionnaires, which have ill-served advisors because they conflate tolerance of risk with perception of risk while ignoring crucial investor propensities of which advisors should be aware.
Behavioral finance researchers Carrie Pan and Meir Statman published their findings on the shortcomings of investor questionnaires in the new issue of the Journal of Investment Consulting. The authors get right to the point in their assessment of these crucial advisor tools, saying in their introduction:
“Many investors who were assessed as risk tolerant in 2007 and assigned portfolios heavy in equities dumped their equities in 2008 and 2009, and some even dumped their advisors.”
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Pan and Statman give five reasons for the inadequacy of questionnaires. First, they say investors have a multitude of risk tolerances, corresponding to the various goals they have for each of their “mental accounts.” They may be intolerant of risking their retirement savings but quite aggressive with funds they’d like to use for jet-setting if they are fortunate enough to generate big returns.
A second problem with investor questionnaires is that they often bear no relationship with actual portfolios. For example, the questions designed to explore an investor’s risk may involve job opportunities, which fit into a different mental account for most investors than their portfolios.
The authors also note that risk tolerance is highly influenced by circumstances, such that questions asked after a period of high stock market performance are likely to magnify investors’ risk appetite and vice versa following periods of low returns.
A fourth area of concern for advisors using questionnaires is the investor’s propensity for hindsight and regret. Some investors will shrug their shoulders at losses, while others will fire their advisors or even sue them for guiding them to unsuitable investments. This is a characteristic that a proper questionnaire should measure.
Finally, some investor propensities—such as high risk tolerance and overconfidence—are closely linked. So there is a danger that current questionnaires will, as a result, exaggerate an investor’s risk tolerance.