Risk Tolerance Profiles Miss Key Questions

Measuring risk tolerance is critical, say experts in the field of risk tolerance and decisionmaking, but few retirement plan sponsors and advisers in the U.S. do it correctly.

Most retirement plan advisers and plan sponsors are not getting at the investor’s real risk profile because they do not ask the right questions, contends Tyler Nunnally, a U.S. strategist for the Australian financial services company FinaMetrica. “It’s a matter of the questions that are being asked,” he tells PLANADVISER. Most risk assessment tools in use don’t measure true risk tolerance because they’re combining the issue of the time horizon—the amount of time a younger investor has to correct mistakes and market ups and downs—with risk tolerance itself.

John Grable, professor of financial planning at the University of Georgia in Athens, says the typical five- or 10-question scale used for 401(k) plan risk assessments scare him to death as a researcher. He is only half joking. “Typically, what you see is they’re asking different questions,” he tells PLANADVISER. Time horizons are very important to think about when you’re allocating assets, but these have nothing to do with your willingness to take risk,” he says. “Whether you are young or old has nothing to do with your willingness to take risk.”

“Risk capacity and risk tolerance are two separate things,” Nunnally points out. In the U.K., where he spent a substantial part of his career, regulators have scrutinized investor risk tolerance assessments, and some common measures were found “not suitable for purpose.” Some of the questions were found to be “not answerable” or “not understandable.” Nunnally explains that many of the questions were too wordy or required an overly advanced understanding of investments.

U.S. regulators have not subjected risk tolerance assessments to the same scrubbing, but Nunnally points out that in the wake of the financial crisis, FINRA in fact added “risk tolerance” as an explicit factor for advisers to assess before making an investment recommendation. However, there has been little accompanying guidance on best practices and methodologies to do risk tolerance assessments, he says. There has been some discussion about how to address risk tolerance for those nearing retirement.

No Context

According to Nunnally, the typical risk tolerance profile in the U.S. measures an investor’s responses to isolated questions removed from context. “They administer the test and then say, ‘This is your profile.’ We call those portfolio pickers,” he says. The questionnaires do not address the investor’s risk capacity and other components of a risk profile.

Standard risk questionnaires do not go far enough, Grable feels. “One reason they make us nervous is that you’re getting an answer, but you don’t know what it’s measuring,” he says. “They’re designed to help investors choose portfolios and investment vehicles.”

A common question asks the investor to imagine that the stock market tumbles 20%. Would the investor buy more? Keep or sell his holdings? “They will give you a few options,” Grable says.

However, answers are heavily influenced by the market environment. “If I asked someone that question during a bull market, they would answer entirely differently than they would during a period of heavy volatility. People do not answer accurately,” Grable says. The reason is an optimism bias. “Most people, particularly men, overestimate their willingness to hang in,” he says.

A more holistic approach is called for, Nunnally feels. One aspect is delving into how much downside discomfort an investor thinks he can withstand emotionally. “This is a matter of conversation with the adviser,” he says. Questions would run along the lines of how the investor adapted to financial disappointment in the past, and what the emotional impact was, and could the investor stomach a 20% fall in the market?

“The questions are a starting point, not the endpoint,” Nunnally says. Plan sponsors and advisers need to see what kind of emotional impact distressing financial events might have on a participant. If the impact was significant, the appropriate thing is to try to avoid a situation where there could be a repeat of that distress.

Goals to Reach For

The investor’s end goal is also critical. “What do they want to achieve, and where do they want to be at retirement?” Nunnally asks. Now the adviser can begin to examine the amount of risk an investor might need to take on to reach those goals.

Grable outlines four areas that can form a more complete picture of someone’s risk profile. First is the investor’s preference for particular types of risk. Some people want to avoid risk, while others like to gamble, he says. Next, what is the investor’s perception of risk? One person might evaluate risk based on loss of money versus choosing safe options that carry the least amount of risk. Others might be able to accept some percentage of risk.

Third, a person’s actual capacity to take risk should be assessed. Someone might prefer to avoid risk because he prefers to avoid losses, Grable notes. But the investor with enough insurance, a solid emergency fund and other supports that make it possible to take a potential loss without feeling too much shock has a different outlook than someone lacking these buffers. “We think people who faced loss and didn’t have ability to withstand tended to be the ones who panicked and made the most dramatic asset-allocation shifts,” he says, “and quite often these are the least optimal decisions.”

Composure is the fourth component of a risk profile. What has someone done historically? Even with a rock-solid foundation that can withstand loss, people can make inconsistent choices. These traits may not lineup in linear fashion necessarily, but they form a more complete profile, Grable explains.

The reason to strive for a more accurate risk tolerance profile, Grable says, is that it can make investment choice and retirement planning more effective. “The whole point of a risk profile or measuring risk tolerance is to help the plan participant create a portfolio that does two things,” he says. “Reach retirement objectives, and also make sure that allocation or fund selection is appropriate, and not too excessive so that if markets fall, they panic. You’re trying to be somewhat predictive of their behavior, particularly in a down market or stressful financial situation.”

The problem is, Nunnally contends, is that most tests simply give a score without any basis for comparison. “The only way to know what a score means is in comparison to someone else,” Nunnally says.

“People lie to themselves, but not maliciously,” Grable says. Everyone assumes that the questions commonly used work, but very few have been empirically tested. Research has not yet really entered the industry’s consciousness, he feels, but this could be changing as people become more aware of the nuances that plan sponsors and advisers need to use to help participants make investing decisions.