He notes that most advisers probably use questionnaires with 15 or so questions to evaluate a client’s risk tolerance. The questionnaires ask about such things as when the client needs to withdraw assets; what other assets the client has; the client’s knowledge level about investments; and what the client would do if markets declined. The client gets a total risk score based on his or her responses.

Kitces told attendees of the National Tax-deferred Savings Association’s (NTSA) 2014 403(b) Summit that advisers are really asking questions about three different things through these questionnaires. First is risk capacity, or the capacity to take risk based on the ability of the investor to absorb losses without getting wiped out. Next is risk perceptions, or what does the client actually define as risky investment behavior. Last is risk attitude or tolerance, based on considerations around how the client feels about risk/return tradeoffs, whereby taking risk means there could be a bad outcome or there could be great gains.

Kitces said there needs to be some way to account for the difference between risk capacity and attitude, separating time horizon and income needs from people’s willingness to trade off. “For example, we tell young folks, ‘You’re young, you should take more risk,’ but we don’t even ask if that’s going to make them nervous.”

For retiring clients, Kitces posed two scenarios. One retiring client doesn’t need much money, and doesn’t need it for many years because he has a large portfolio, and another client needs lots of money immediately and has less in his portfolio. Both are conservative investors. The first one’s questionnaire scores will average out to indicate he should invest in a moderate portfolio, Kitces explains, but because of his low risk tolerance, it’s just a matter of time before he has losses that are personally devastating to him. In addition, just because the client has the capacity doesn’t mean he should take the risk. The second client’s questionnaire scores will indicate he should invest in the most conservative portfolio, but this portfolio will fail to meet his need to accumulate lots of money.

“These are some of the core, essential problems with traditional risk evaluation,” Kitces said, noting that there is no easy solution for the second person in his example. “If he has a low risk tolerance, he cannot get high income, so he needs a different goal.”

A high risk capacity allows for any risk attitude, but a low risk capacity requires a high tolerance, he added. Risk attitude defines the upper limit of risk to take.

Risk perception presents another problem. Kitces said it seems clients have high risk tolerance in good markets and low tolerance in bad markets. But the problem is not that their tolerance changes, he warns. The problem arises when clients start thinking a short-term market trend is indicative of long-term results. This could lead them to misjudge risk and make bad decisions. Clients tend to remember most clearly what has happened most recently.

“This is where education and financial literacy matters,” Kitces said. “Advisers must do constant educating so client perception is realistic. Perception is something we can actually help clients with.”

However, advisers need to start separating risk capacity from risk tolerance, according to Kitces. “Just because someone may have a large portfolio or a long time horizon, we shouldn’t violate their risk tolerance and give them an overly risky portfolio,” he concluded.