As a financial advisor, chances are you are well acquainted with the risk profile questionnaire. While they come in many varieties, the basic premise remains the same.
A group of roughly 10-20 scenario-based questions are presented to the client, typically at the onset of the relationship, in which he or she responds based on their general attitude toward market risk.
At the end, each answer corresponds to a numerical value where upon the sum of these values are used to prescribe an overall level of risk (i.e., 0-10 is very conservative, while 90-100 is very aggressive).
While a responsible and prudent advisor will obviously go into greater depth in an effort to better understand an individual’s overall financial standing, the risk profile questionnaire, nonetheless, has earned a reputation as an integral tool in assessing appropriate levels of risk, documenting the understanding between the advisor and client, and supplying a potential safeguard in the event of a branch audit.
However, in spite of all of this, it is perhaps time to call their usefulness into question as they can neither predict nor identify an individual’s behavior when confronted by real or, perhaps more important, perceived periods of risk.
Perceptions of risk and behavioral biases exist in all investors to a certain extent. This characteristic, which is currently unquantifiable, exposes the shortcomings of the risk profile questionnaire.
For instance, how often does a client come in to your office, complete a risk profile questionnaire, score in the aggressive category and subsequently panic at the first sight of a market correction out of fear that they will never recover these loses?
Conversely, how often do people score very conservative on a risk profile questionnaire as they perceive the markets to be too risky only to view their 401(k) statement and see that they have invested solely in large-cap growth funds as they perceive these funds to be “safe”? The risk profile proves to be useless in such scenarios as the perceptions of risk and behavioral biases are clearly dictating their decisions.
German Philosopher Friedrich Wilhelm Nietzsche once said, “There are no facts, only interpretations.” Despite these wise words, it is common for an individual, particularly an investor, to intertwine their perspective with what they consider to be irrefutable fact.
If a client perceives that their investments are facing imminent risk, even if that notion is not rooted in reality, the propensity to fall into a behavioral trap becomes much more likely, potentially causing irreversible damage to financial goals.
To further illustrate this point, let’s review some data from the most recent presidential election. The National Bureau of Economic Research recently published a study concerning how political party affiliation affected investors’ choices.
Research showed that following the election of Donald Trump, investors who identified as Republican increased their exposure to domestic equities while those who identified as Democratic responded by increasing their overall allocation to bonds and cash-equivalent securities, Bloomberg reported.
For Republican-leaning investors, the impulse to trade along with their political beliefs happened to work in their favor; however, it should be noted that their success in this instance is rooted in luck and not intelligence.
For our investors who identify as Democrats, it is unfortunately quite likely that this allocation shift caused major changes concerning their financial goals and objectives, likely not to their benefit.