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.”

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.

Pan and Statman offer examples of questions asked by Vanguard, FinaMetrica and others and show how they sometimes bias the measurement of risk tolerance by blurring distinctions between correlated characteristics such as confidence and tolerance. The authors offer their own questions that attempt to capture a clear image of risk tolerance, and along the way they offer a variety of behavioral finance insights.

For example, they point out that the amount of wealth an investor has at stake influences perceptions of risk, which in turn affect risk tolerance. For that reason, a Vanguard investor questionnaire that asks investors to rate their attitudes toward gains and losses in a hypothetical $10,000 portfolio may be irrelevant to an investor concerned about a $1 million retirement portfolio.

Another insight contrasts risk tolerance involving jobs versus portfolios. While very young but also older people are willing to take risks with their jobs (but not those in the middle), risk tolerance toward portfolios steadily decreases as a function of age.

Pan and Statman offer specific guidance for financial advisors based on a number of behavioral finance findings. For example, “advisors need to adjust downward their assessment of the risk tolerance of overconfident investors and perhaps tamp down their overconfidence as well.” Such clients are likely to resist diversifying their portolios and holding rather than trading stocks.

A propensity to regret is a key issue for advisors since all investor choices, be they aggressive or conservative, “open the door to regret.” While a conservative portfolio is bound to disappoint such an investor in a period where stocks take off, low-risk portfolios nevertheless may shield advisors from lawsuits in contrast to high-risk portfolios coinciding with a stock market meltdown.

Another key investor attribute, often ignored by investor questionnaires, is life satisfaction. Pan and Statman show that while high-income earners generally have greater satisfaction than poor people, and older people tend to be more satisfied than younger people, a key determining variable is the investor’s benchmark. If someone with $1 million wants $2 million, he is likely to be less satisfied than someone with $50,000 who’d be happy to have just $40,000.

The authors call for the development of a new investor questionnaire that goes beyond risk tolerance measures to include “information about clients’ overconfidence, propensities for maximization, regret, attributing success to luck over skill, trust and life satisfaction.”


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