Are Risk Tolerance Questionnaires A Silly Waste Of Time?
June 7, 2016
by Scott MacKillop
Seth Klarman Tells His Investors: Central Banks Are Treating Investors Like “Foolish Children”
"Surreal doesn't even begin to describe this moment," Seth Klarman noted in his second-quarter letter to the Baupost Group investors. Commenting on the market developments over the past six months, the value investor stated that events, which would typically occur over an extended time frame, had been compressed into just a few months. He noted Read More
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
When a prospective client walks through the door, a financial advisor wants to know three things: their return objective, their time horizon and their tolerance for risk. Financial planning research has systematized the first two tasks. But the attempts to quantify risk tolerance have failed to produce positive outcomes for investors.
Calculating a return objective is straightforward. You learn how much the prospect has now and how much more they want in the future. You find out how much time they have to close the gap. You do some math and there you have it – a return objective. Of course, you may have to make a few assumptions and press the prospect for information they haven’t thought much about, but the calculation itself is simple.
The same is true about the time horizon. You will have to make some assumptions about life expectancy and ask the prospect for information they may not be sure about, like remaining years in the work force. But once you have gone through this exercise, you emerge with a number. It may not turn out to be the right number – the prospect may die earlier than you assumed – but it is a concrete number derived from objective, measurable information.
How do you measure risk tolerance?
What about risk tolerance? How do you measure it? Can you calculate it using simple math? Can you calculate it at all? Can you even define it in a meaningful way? It is easy to see that there are really two very different varieties of risk tolerance: one is attitudinal and subjective, and the other is objective and measurable.
I’ll look at the objective variety first. Let’s say my goal was to have $2 million by the time I retire at age 65. Now I have arrived at my retirement date, and I have $3 million in my account – significantly more than I need. My goal should be to take as little risk as possible while maintaining the purchasing power of my assets. Objectively, I should have no tolerance for risk.
On the other hand, let’s say my goal is to have $2 million when I retire in five years. But I only have $1 million today. Objectively, this means I should have a high risk tolerance. Few investments can generate the 14% to 15% annualized return I will need to reach my stated goal and they are all very risky. I have no choice. I need to take risk to reach my goal.
This objective type of risk tolerance determination has nothing to do with my internal feelings, attitudes or beliefs about risk. It is all driven by my goals and my time horizon.
Now let’s talk about the attitudinal variety of risk tolerance. This is what risk tolerance questionnaires attempt to measure. They do this by asking questions designed to reveal our true predisposition toward, and probable level of comfort with, risk. Some of the questions are very direct in asking us how much risk we are comfortable with or how we rank ourselves along the spectrum of risk-takers. Other questions ask us to report how we would behave in the face of various scenarios, some of which involve investing and some of which don’t.
Can we measure risk tolerance with a questionnaire?
Many of these questionnaires synthesize our answers into a risk score. These scores may label us as conservative, moderate, etc., or they may actually assign us a single number, like a 42 or a 78. Some are even designed so that these scores determine what investment strategy is appropriate for us. I am a 42 so I should have the 40/60 portfolio, and you are a 78 so you should have an 80/20 portfolio.
In other words, comfort with risk determines strategy.