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Disservice of Risk Tolerance Questionnaires


In Regulatory Notice 12-25, FINRA provides additional guidance on the issue of “suitability.”  Specifically, they state “a broker must have a reasonable basis to believe that a . . . investment strategy . . . is suitable for the particular customer based on the customer’s investment profile.” [2]  FINRA goes on to specify“The new rule broadens the explicit list of customer-specific factors that firms . . . must attempt to obtain and analyze when making recommendations to customers.  The new rule adds a customer’s . . . risk tolerance to the explicit list of customer-specific factors . . .”  In response to this rule and its predecessors, the investment industry has developed the risk tolerance questionnaire  –  a short set of questions that the retail investor is required to answer.  The results are then numerically scored and generally summarized as a single number, which the advisor or financial planner uses as the client’s specific risk tolerance.  For example, you have a risk tolerance of “2” therefore you are conservative, while I have a risk tolerance of “8”, therefore I am aggressive.  Advisors who rely on such an approach then select the portfolio lying on the efficient frontier that corresponds to their risk tolerance number.  Simple, straightforward, and fully documented.  Unfortunately, there are a few problems with this approach.



Academic economists have a long history of building abstract, simplified models of consumer and investment markets and associated behaviors.  In such theoretical models, academics assume that consumers (investors) base their individual decisions on simple utility functions (these are short algebraic equations that are then maximized to determine the outcome of any given consumer decision).  Utility functions have a single variable sometimes referred to as the function’s risk tolerance.  FINRA’s mandate to identify a client’s risk tolerance is effectively based upon this academic, over-simplification of the real world.  A few problems exist.


Today, it is widely appreciated that risk tolerance is not a clean, crisp economic factor unique to each rational economic-person.  Instead, it is understood to be a fundamental psychological trait [3].  As a psychological trait, it is inconstant, nondurable, and ever-changing.  Worse yet, it has proven to be highly path-dependent.  In other words, how one scores on a risk tolerance questionnaire will critically depend on recent investment market returns and volatility.  In essence, risk tolerance questionnaires are heavily emotion-driven.  As one set of academic researchers observed “Emotions are confirmed to drive the financial risk-taking process, enhancing the accuracy of the individual risk tolerance forecasting activity.” [4]


Worse yet, research on decision-making processes used by consumers and investors appreciates that risk is not a one-dimensional attribute, but instead entails a complex and unstable multi-dimensional array of factors [5].This multi-dimensional attribute all but dooms risk tolerance questionnaires to the irrelevant (at best) or the misleading (at worst).  Consider for a moment one of the most carefully developed tests in the last century.  The Scholastic Aptitude Test (SAT) has been given to high school students since its first introduction in 1926.  During the last 87 years, it has been continuously refined and improved based on eth many millions of test results.  Despite its extensive four-hour lengthand its near-century of refinement, it remains a terrible predictor of college success.  SAT scores and college grades correlate at around 0.4  –  a terrible outcome [3].  Consider then, what chance a simple risk tolerance questionnaire, to be completed within three or four minutes, has in identifying a fundamentally multi-dimensional psychological attribute that has been misspecified as one-dimensional.  Risk tolerance questionnaires are a direct and immediate disservice to our very genuine need to best meet our client investor needs.


As one team of researchers examining risk tolerance questionnaires observed “Our findings show that misclassifications resulting from the questionnaire are massive:  individuals asked to self-assess their risk tolerance reveal a high probability of failing their judgment, i.e., they behave as if they were risk takers, while defining themselves as risk-averse (and vice versa)” [4].  So what’s to do?



FINRA Rule 2111 requires “customer-specific suitability” [2].  In other words, that the investment solution provided by the advisor fit well with the relevant attributes that define the retail client’s needs, objectives, and circumstances.  Observe that the selection of an investment solution implies three specific characteristics about the criteria used for such selection:


  • Relevance   –   The criteria is relevant to both the client and to the investment solution under consideration,
  • Understanding   –   The criteria are adequately understood by the client, and
  • Control   –   The client is actually in control and is in a position to decide something material about the criteria.


Taking these three criteria together, retail clients understand and control six factors that are relevant to their financial journey:


  • Spending   –   How much is needed for consumption (the client’s lifestyle and each individual “spend”),
  • Savings   –   How much to set aside for investment (how much to save),
  • Timing   –   When the client wants savings and spending to occur,
  • Risk   –   How risky or volatile an investment portfolio to maintain (where the client wants to be on the efficient frontier in a Modern Portfolio Theory world),
  • Legacy   –   What assets the client wants to transfer to heirs (or to charities), and
  • Surety   –   How certain does the client want to be that the tradeoffs between the five competing needs above add up.


It is important to observe that these six factors are at odds or in conflict.  Generally speaking, more of one requires less of another.  Thus the client must make decisions about the tradeoffs between these six competing factors.  By using software tools such as eMoneyAdvisor, MoneyGuidePro, or Financeware, the advisor is able to interactively and collaboratively engage the client in a robust discussion of these six factors and to explore the tradeoffs that the client seeks to make between them.  The result of such an exercise is a robust understanding on the part of the client as to their own personal objectives, the potentially harsh realities that exist, and the tradeoffs that must be made.  The discussion and collaborative exchange produces two follow-on outputs:


  • The Normal Policy Asset Allocation (the efficient frontier portfolio in a Modern Portfolio Theory world) and
  • A set of follow-on issues for regular periodic examination by the client and advisor.


Observe that nowhere in this process was the client ever asked to score or rank their risk tolerance through some sort of questionnaire process.  Yes, in full compliance with FINRA Rule 2111, both the client and advisor are developing a deep understanding of the client’s perspective on risk and comfort with it.  This understanding results from the interactive process of exploring the tradeoffs between the six competing factors identified above  –  more of one means less of another, e.g., if the client desires greater surety, then they must accept lower spending.  This approach avoids the artificial, unstable, path-dependent, one-dimensional nature of risk tolerance questionnaires.  But its real benefits are even greater.



The process outlined above, focusing on the six factors that are understandable, controllable, and relevant to the client’s financial journey, provides a dynamic framework for dealing with life’s ever-changing nature  –  unlike the risk tolerance questionnaire.  Let’s be honest, the world changes over time and therefore the nature of the six factors under the client’s control must also change.  The world surprises, so no matter how solid a client’s financial plan, no matter how competent its initial implementation, the instant that it has been inked or implemented, it has also become stale and outdated.  A “Financial Plan” is the ultimate in irrelevance.  Life happens, so what is needed is a dynamic process that provides a “Continuous Planning Process.”  Such a process allows the client to adjust decisions across the six factors under their control to life’s surprises, reflecting the unexpected and unplanned arrival of tomorrow’s new and different reality.


Under such a framework, returns are not the objective.  Outperformance is not the objective, and the scoring on a risk tolerance questionnaire is not the objective.  The first two may contribute to a best-possible journey, but they are never the objective  –  and in fact distract from what is important, i.e., obtaining a best possible decision with respect to the six factors.  Through the use of software tools such as eMoneyAdvisor, the advisor and client can reengage on a regular periodic basis (or whenever life happens) to ask the questions “How am I doing?” and “How is my funded status?”  Competing decisions between the six factors can be reevaluated and incremental adjustments made.  For example, perhaps returns were higher than projected.  This would allow for a larger legacy, greater spending, lower savings, or higher surety.  But the client is in control and must make a decision between these opposing factors.  But changes in this simple example result from an externally imposed surprise (higher returns than had been projected) and as a result of a tradeoff decision made by the client  –  and not as a result of some new scoring drawn from some foundationless and unstablerisk tolerance questionnaire.


Finally, such an approach provides a significant opportunity for the advisor to build a more substantive, value-added, and ongoing relationship with his client.  This beneficially moves the relationship away from return chasing, questionnaire-based, one-time financial plans.


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