Risk tolerance is an individual’s general willingness to take risk in managing their financial affairs.
Risk tolerance reflects the balance between having too much risk and too little. An investor would not want to be overexposed to risk, thereby putting his or her financial well-being in danger. Nor would a person want to be underexposed to risk and miss out on financial opportunities. So risk tolerance is relevant to how people manage their financial affairs and, in particular, how well they sit with the riskiness of their investments.
There are many myths about risk tolerance, what it is, and how it can be measured and applied in the financial planning process. Risk tolerance is commonly confused with other risk attributes such as risk behavior or risk capacity. FinaMetrica has examined 10 common myths, tackles the assumptions behind them and explains the reality.
People’s risk tolerance is variable. When markets are rising, their risk tolerance is relatively high, but their tolerance falls when markets crash.
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Risk tolerance is typically set by early adulthood and it decreases only slightly with age. Clients’ risk tolerance scores generally remain stable through the gyrations of the markets, though a major life event such as marriage or having children can change risk tolerance.
Notice from the chart below how little FinaMetrica risk tolerance scores changed through the market crash of 2008-2009. What changes as markets swing is more often investors’ risk behavior driven by their perceptions of risk, not their risk tolerance.
Our test scores risk tolerance on a 0 to 100 scale, mean 50 and standard deviation 10, and approximately 800,000 tests have been completed to date. We have periodically published monthly average risk tolerance scores, which are, in effect, new samples from the same population. Average monthly scores from 1999 to 2015 are shown below.
FinaMetrica’s white paper, On the Stability of Risk Tolerance, reports six studies across 10 years that confirm the stability of risk tolerance. In particular, two of the test/retest studies show risk tolerance as being stable across the market turmoil of 2007-2009.
A person’s appetite for risk is the same across all aspects of their life.
Just because a person likes to take physical risks, it doesn’t mean they like financial risks or other sorts of risks. One’s appetite for risk in one area of life doesn’t necessarily transfer to other areas. Jackson, Hourany and Vidmar (1992) propose, for instance, that risk tolerance has four levels: financial, physical, social and ethical. While there is some evidence of generalized risk taking, there is stronger evidence of consistency within, but not between the different facets.
So someone who, for example, never buys shares and sticks to cash may be an avid paraglider. Or a chronic gambler may tremble at the thought of mountain climbing or have their life insured.
Risk tolerance will determine asset allocation within an investor’s portfolio.
A risk tolerance assessment should tell the advisor the risk an individual is prepared to take in their financial affairs, but it is the risk profiling process that provides a proven methodology to ensure the suitability of investment advice.
Historically and even currently, many financial services companies and financial advisors have mistaken asset allocation calculator questionnaires for risk tolerance tests. The ambiguity of these tests has led to confusion regarding clients’ risk tolerance. This is because questions relating to risk capacity, time horizon and financial situation form part of a questionnaire that suggests that “we propose asset allocations based on your stated investment objectives and experience, time horizon, risk tolerance and financial situation.”
FinaMetrica’s white paper, Risk Profiling: Art and Science, explains the risk profiling process in detail and the need to scientifically and individually assess risk tolerance in that process.
Risk profiling involves finding the optimal level of investment risk for a particular person. The following factors need to be assessed when conducting a risk profile. Risk required is the risk associated with the return needed to achieve goals. Risk capacity is the level of financial risk the client can afford to take, and risk tolerance is the level of risk that the client would prefer to take. Risk profiling requires each of these characteristics to be assessed and compared to one another.
Often a mismatch exists between risk required, risk tolerance and risk capacity. Trade-offs then become necessary to solve these mismatches and give suitable financial advice to an individual.
The final step in the risk profiling process is to ensure that the client has realistic risk and return expectations so they can give their properly informed consent and implement an investment strategy on their behalf. The client must make their own decisions according to their own values and financial situation. So risk tolerance alone would never determine an asset allocation; understanding it is essential for both the investor and the advisor.
Risk tolerance testing is subjective and involves test providers applying their own judgements to measurements made.
While some risk tolerance tests are subjective, this is not the case if the test is psychometric. Over the past 50 years, the discipline of psychometrics has been developed by psychologists and statisticians to measure psychological traits such as risk tolerance and intelligence.
Psychometrics provides a well-established scientific discipline for assessing risk tolerance through questionnaires and the application of internationally accepted psychometric standards. Such tests, as long as they are reliable and valid, provide objective measures of risk tolerance. Valid means the questionnaire measures what it purports to and reliable means that it does so consistently with known accuracy.
Both versions of FinaMetrica risk tolerance tests exceed international psychometric standards with, respectively, reliabilities of 0.90 (25-question) and 0.84 (12-question) and 95% confidence levels of ±8 and ±10.
As mentioned, many risk tolerance tests in the market don’t just assess risk tolerance, they often include questions relating to other matters including risk perception and risk capacity. These tests are flawed as they are likely to give inaccurate readings of risk tolerance given that they ask about irrelevant factors. See Myth 6 for more details.
Financial advisors can accurately estimate their clients’ risk tolerance.