What we talk about when we talk about risk profiles

Client risk profiles can be messy and complex. Even the language is confusing, with people frequently using terms like “tolerance,” “capacity,” “preference” and “composure” interchangeably. There is no established standard for measuring tolerance or preferences, and yet the expectations of regulators and clients continue to move in the direction of ultra-personalization.

With so much noise and confusion around the topic, how can advisers properly vet the tools they use to create client risk profiles? It comes down to a few clear definitions, along with a couple of critical questions to ask of any tool you’re considering putting to use.

DEFINITIONS

First, let’s get clear about language. I’m going to lay out three important parts of any client risk profile and exactly what I mean by each term.

1. Risk capacity. A person’s capacity for risk is essentially the amount of money they can afford to lose without sacrificing their long-term financial plans. People with very little slack in their finances will have a lower risk capacity because they cannot afford to lose very much at all, while those with greater means will be able to handle greater risk given the additional buffer of assets above and beyond what it takes to provide for their basic needs. Risk capacity is a mathematical calculation that can be estimated based on the client’s assets and time horizon.

2. Risk tolerance. A person’s risk tolerance is their conscious, rational attitude toward risk when they are not emotionally aroused. When thinking through the trade-offs of risk and potential reward, what level of risk does the person believe is appropriate and tolerable to them? It’s important to differentiate between tolerance and composure (defined below). Risk tolerance is psychometric and can be reliably measured through validated psychometric questionnaires.

3. Risk composure. A person’s risk composure is their ability to regulate their emotions when facing volatility. Someone who is very composed will not deviate from their long-term strategy in the face of volatility, while a person with less composure may pull out of down markets or jump into overheated ones. Risk composure is a psychophysiological metric and is very difficult to measure. Often, advisers must rely on their observations of client behavior in various circumstances to fully gauge a client’s risk composure.

ALL THREE MATTER

Capacity, tolerance and composure all matter when choosing an investment strategy. Capacity puts realistic bounds on risk exposure based on individuals’ long-term needs. Tolerance puts bounds on risk exposure based on their tastes, style and preferences, and composure may further constrain risk exposure based on their ability to “stomach” ups and downs.

You don’t want to build a long-term plan on a client’s transient emotions, and yet you also don’t want to ignore their level of emotional regulation (or lack of it). For long-term plans, it’s reasonable to base the broad investment strategy on their capacity and their tolerance metric, and then adjust that strategy based on your assessment of their composure. However, to do this, you need to know what, specifically, is being measured, and how well. Most tools don’t do a great job of explaining this, and so it’s useful to know what to ask when considering risk profiling tools.

VETTING PROFILING TOOLS

When assessing the tool or tools you use for risk profiling, you need to know two things:

1. What, specifically, is the tool measuring? Some tools measure tolerance and others estimate composure. If one tool claims to measure both, I’d find that highly suspect since measuring tolerance requires a calm mental state and measuring composure requires an aroused emotional state – one tool isn’t likely to do both very accurately and cleanly. Ideally, you’d have separate measures for each of the three dimensions. Capacity can be calculated from financial statements and time horizon. Tolerance can be assessed with a validated questionnaire, and composure can be estimated based on past behavior in volatile markets.

2. Whatever it is measuring, is it measuring that thing reliably? A reliable tool will give you the same answers even if you use it on different days. A person’s composure may be erratic, but tolerance (that cool-headed, rational attitude toward risk) doesn’t change as much as emotions do. If the tool cannot produce a reliable tolerance score, it’s not an ideal tool for the task. 

In sum, risk profiles are complex and multifaceted, but not impossible to get right. What matters is having clear definitions and reliable measures, and then using your best judgment to weigh that information when crafting a personalized plan.

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Sarah Newcomb is a behavioral economist at Morningstar Inc.

Related Topics: Morningstar Inc., Risk Management