Rethinking traditional risk questionnaires

It's one of the first things you ask a new client and forms the bedrock of the retirement planning you will do together. “Are you a conservative, moderate or aggressive investor?”

The client answers a quick five- or 10-question survey and voila, out pops the appropriate model portfolio.

But there is a growing body of knowledge about other more effective approaches to helping clients realistically assess their risk tolerance. Using the prism of behavioral economics, we can develop a deeper understanding about how investors perceive risk and act in the face of it.

PREDICTING THE FUTURE

What stands in the way of developing a robust, reliable, valid risk tolerance questionnaire? A big part of it is that humans stink at predicting the future, especially when it involves trying to imagine how we'll feel if certain things occur.

Advisers can help clients do a better job of realistically assessing their risk appetite by asking more concrete questions. Instead of “Can you tolerate a 10% drop in the market?” try framing it less abstractly: “Can you tolerate a $100,000 loss in your $1 million portfolio?” You are likely to get a more realistic answer.

As it turns out, timing matters. When it comes to assessing risk tolerance, studies have found that investors usually display a greater tolerance for risks after a rising-market period than a declining-market period. So advisers might consider asking one set of questions after a strong market and a different series of questions after a weak market.

When clients answer the typical risk assessment questionnaire, they attempt to use their imagination to foresee what they might feel like in the event the market goes down or up.

As it turns out, there are multiple problems with this.

• People tend to remember only the extremes, which are not the norm.

• Most of us fail to remember details of past events. Only the major features stand out. The details distinguish one scenario from another.

• Mental re-creations of past events tend to be abbreviated.

• It's difficult to re-create true emotional states in one's imagination.

RISK TOLERANCE

Even when planning for retirement, risk questionnaires typically fall short of achieving the goal. Questionnaires may ask an investor's age but not when the investor plans to retire, or vice versa. The financial adviser needs to understand both components along with expected sources of income upon retirement.

Of special interest in retirement planning are questions about the investor's time horizon, including when planned withdrawals are to commence.

What these questions often miss is the individual's intent. That is, what does the client plan to do with the money? Understanding this aids in portfolio construction.

SPENDING PRIORITIES

It could be as simple as asking: “How do you expect to spend your investments in retirement?” And then offering the following choices, allowing the client to select and rank all that are relevant.

• Living expenses

• Donations

• Family activities

• New house, car or boat

• Travel

Having a priority list can help guide asset allocation.

Use relatively safe assets to fill the buckets representing the most important goals while riskier assets can support less important objectives.

Investors may find it easier to understand risks if you can point to the security and insecurity involved in satisfying each specific goal.

Economists say that if you really want to know what people think, don't ask them, watch them. It may be time to approach the concept of risk tolerance with fresh eyes.

Behavioral finance can provide a helpful lens into investor behavior and their real propensity for risk.

Brian Jacobsen is chief portfolio strategist at Wells Fargo Funds Management and an associate professor at Wisconsin Lutheran College, where he is director of the financial planning program.