Blue Chip Issue 81

RISK TOLERANCE
The perils of risk
tolerance questionnaires
Where you (the financial planner) can bridge the gap
Understanding your client’s capacity for risk is key to
advising them on a sound investment strategy. Failure
to do this correctly may result in an excessively risky
portfolio requiring more frequent rebalancing, or
too conservative a portfolio which doesn’t achieve the client’s
investment objectives.
There are a variety of methods to assess risk tolerance, but
questionnaires remain the simplest and most common. Because
of that, they need to be psychometrically sound. They need to
assess cognitive (thinking) and affective (emotional) elements, and
they also need to be valid, reliable and consistent.
This last point is something that piqued my interest a while
back. Risk tolerance differs from one individual to another and is a
function of socio-economic and other personal factors. Thus, surely
a risk tolerance outcome should be unique to the individual, not
dependent on the type of assessment tool?
So, my team did a little study. We sourced several risk tolerance
questionnaires and created four hypothetical individuals: we
needed someone who was very risk-averse and another person
who was very risk-tolerant, and two others somewhere in between.
To do this, we assigned different characteristics to these individuals
that are predictive of risk tolerance, such as level of financial literacy
and age (to name a few). Then, we completed each questionnaire
four times – once for each individual. We wanted to see whether
the results were in line with the expected outcome for each of the
individuals and whether they were consistent among the different
questionnaires. The results were as follows:
86 www.bluechipdigital.co.za