The risk tolerance questionnaire has been a staple among financial advisors for a long time. Although the questions vary from one questionnaire to the next, the end goal is the same: to predict the client’s potential reaction to market fluctuations and potential losses in their portfolio. It is also used to determine an appropriate allocation between stocks, bonds, cash, etc. These questionnaires will typically assign a numerical value for each answer and when all points are totaled, the resulting sum will help determine the client’s willingness to assume risk and ability to tolerate losses.
Although the majority of these questionnaires use a numerical system, I have abandoned this approach as I believe it over-simplifies a rather complex issue. At issue is the complexity of the human brain and reasoning processes of the individual. It is my view that all such processes are highly subjective and any attempt to objectively quantify them is impossible. In this post, I’ll discuss the questionnaire I’ve developed and elaborate a bit more on its components.
The 4 Sections of Patton’s Risk Questionaire
My risk questionnaire contains four sections: 1) Income Needs; 2) Prior Investment Experience; 3) Risk/Return Expectations; 4) Other.
Section One: Income Needs
Money managers understand that the timing and amount of withdrawals is essential information in portfolio construction. Therefore, I ask two questions: “When do you expect to begin making withdrawals?” and “Do you expect your cash flow to increase, decrease, or stay the same in the next three to five years?”
Section Two: Prior Investment Experience
This section contains four questions. First, “Have you ever handled your own investments? If so, was it a good experience?” I also ask how knowledgeable they feel they are with respect to the financial markets. For example, if they handled their investments during a raging bull market, do they attribute their performance to their skill or did they get lucky? I also ask this in general terms. For instance, “What percentage of portfolio gains and losses are due to skill versus luck?” Finally, past experience greatly influences current perception, and we all understand that a person’s perception is their reality, even if it’s incorrect. Correct or not, as their advisor, this is information we need to know. This leads us to section three.
Section Three: Risk/Return Expectations
“What return do you expect to earn over the ensuing three to five years?” “Which is most important, preserving principal or substantial portfolio growth?” “How would you react to a loss in your portfolio?” I also have six hypothetical portfolios and ask them to select one. Many questionnaires have only three portfolios which is highly inadequate. Why? Because the first choice is usually too conservative and the third choice is too aggressive. I believe this is why the vast majority of individuals will select the middle option, which offers little insight. Understanding exactly what they expect is vitally important!
Section Four: Other
This could be named the “Behavioral Finance” section. In it, I’m looking for biases and inconsistencies. I believe we all have them and that the difference is really found in the extent to which we differ. This section is designed to uncover these issues.
Learn From the Client, but Protect Yourself
The risk questionnaire is one tool in a toolbox of many tools which helps get the conversation started. I also have the client initial each page and sign the last page. In short, this needs to be part of the formal record of what the client expects and will tolerate, all of which could protect you from a false claim in the future.
It’s sad, but we live in a litigious environment. Therefore, it’s crucial to understand what the client expects, record it, and do your best to fulfill your role as their advisor.
Until next week, thanks for reading!