How To Best Gauge Your Risk Tolerance
By Larry Cao, CFA Understanding an investor’s risk tolerance is arguably the single most important issue for an investor and their financial adviser to consider. And yet it never seems to get the attention it deserves. The Definition Risk tolerance refers to your ability and willingness to take on investment risk. Specifically, it indicates how big of a loss you can take in the market without changing course. We are all human and abandon ship when things go wrong. (And that’s why we are not fully invested in equities even when it comes to our long-term investments.) Risk tolerance is the threshold at which you’ll head for the exits. It’s important to measure your risk tolerance accurately. Otherwise all your financial plans are just sand castles and won’t withstand the test of time and market volatility. “I did not really understand my true risk tolerance.” This is one of the painful facts many investors came to appreciate following the global financial crisis. Financial institutions often offer their wealth management clients a risk tolerance questionnaire as a way to gauge their risk appetite and capacity to withstand loss. Investors are typically asked anywhere from a few to multiple sets of questions on their investment horizon, their reaction to different levels of market volatility, and sometimes other factors, such as their education, that regulators or financial institutions may deem relevant. The Issue There are two problems with the current risk tolerance questionnaires and how they are administered. First, is the question of what motivates a financial institution to administer such a questionnaire. Far too often, the questionnaire is the product of internal (compliance) and regulatory considerations. Therefore, the questions may not have been designed to accurately measure your risk tolerance. Second, financial advisers, whether fee- or non-fee-based, are directly rewarded for persuading clients to trade or invest with them. Risk tolerance questionnaires are often treated as a hindrance to profit rather than a tool to gain a client’s trust. I think it’s for these reasons that the single most important question for accurately gauging investor’s risk tolerance often does not get asked. That question is: How often do you check your investment performance? The Solution How frequently you look at a Bloomberg Terminal, check your stock performance on a smartphone, or, in a more old fashioned way, call your broker actually matters quite a bit in understanding your risk tolerance. Run-of-the-mill questionnaires generally give ranges of upside and downside related to investment strategies, in dollar amounts or percentages, and ask which one you’d invest in. The horizon is generally assumed to be a year – that’s how often financial advisers typically meet with clients to discuss financial plans. And yet, what these ranges mean to an investor very much depends on how frequently they check the market. As a service to readers of CFA Institute Financial NewsBrief , we asked them that question. (To avoid ambiguity and guesswork, the question was phrased differently in the poll.) And below are their responses. When did you last check your investment performance? Click to enlarge About 41% of the 558 respondents actually checked their performance within 24 hours (including 7% who checked within the hour?!). Imagine the constant pounding they’ll get in a bear market. In fact, if you are part of this group, just think back to how you felt this January. Experience shows that this group is more likely to overstate their risk tolerance on questionnaires and, hence, are most vulnerable to market volatility when it actually hits. When I was a professional money manager, I belonged to this group. It’s kind of a responsibility that comes with the job. But it is just as hard for professional investors to stomach market turmoil as anyone else. As I recall, in the midst of the financial crisis in 2008, when I asked a portfolio manager from a different firm how morale was in the office, he said, “It is really quiet.” By the way, I am not saying all portfolio managers have to monitor their performance this closely. It depends on how your investment strategy works. For example, value strategies tend to require longer investment horizons, so it’s generally okay if a manager does not check portfolio performance every day. The largest group of our survey respondents (40%) check on their portfolios every month. For most investment strategies and most investors, I think that’s probably the optimum. Still, in terms of gauging one’s risk tolerance, that’s a frequency higher than implied in the risk tolerance questionnaire. So this group suffers from the same problem as those noted above. That adds up to about 80% of investors who are probably overestimating their risk tolerance. How frequently you make your investment decisions has direct impact on your risk tolerance. If you invest you own money, make sure you ask yourself that question. If you are a financial adviser, consider asking your clients that question today. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.