Why Risk-Profile Questionnaires Don’t WorkAdvisor Perspectives
In constructing financial plans, I tell clients that the second most important decision they will make is to set the overall riskiness of their portfolio by deciding upon an asset allocation. I’ll disclose the most important decision at the end.
As a financial planner, I’ve been trained to administer what’s called a “risk profile questionnaire” to new clients to determine how much of their portfolio should be in more volatile asset classes like stocks. One of the best such questionnaires I’ve seen is this survey from Vanguard. It asks questions about how clients feel about risk and when they will need their money, with the answers supposedly determining how much risk to take.
Though I’m trained to use these questionnaires, I don’t and here’s why – as well as a better way.
I love the idea that risk tolerance is something that can be quantified by answering certain questions that magically reveal what your asset allocation should be. I’m opposed to using them, however, because reality indicates they don’t work. For example, the Vanguard survey said I should be 80% in stocks, while other surveys I’ve taken put me as high as 90% stocks. The lowest stock allocation I received from a questionnaire I took recently came from Riskalyze at 55% stocks.
According to these questionnaires, I should be between 55% to 90% stocks. Yet I won’t budge from my current target of only 45% stocks for three reasons:
- Our inconsistent desire to take risk
After more than a 10-year bull market, most of us feel pretty confident. It’s easy to feel brave when everything is up. Not so much when stocks plunge. That’s the time when we tend to want to load up on cash. Had I taken these surveys on March 9, 2009 when stocks bottomed out, I would have had a much lower appetite for risk. In fact, data shows advisors fall into the trap of taking on risk after markets surge only to pull risk off the table after a plunge.
- Past behavior in a vacuum
I love Vanguard’s question about how I behave in times of market declines. I agree that past behavior is a good predictor of how investors will behave during the next plunge. I truthfully answer questions knowing that I bought more stocks in late 2008 and early 2009. The problem is that my answer didn’t reveal that it was the hardest thing I’ve ever done in investing – and that was when I was only about 45% in equities. Had I actually been 80% in stocks before the plunge, I doubt I would have had the cash or the courage to rebalance.
- Need to take risk is ignored
I’ve never seen a questionnaire measure one’s need to take risk, by which I mean where the investor stands in relation to financial independence. Though I’m not a big spender, I’m well aware that I can’t take it with me. I personally find that the good thing about being frugal is that I can be rich with less money. In fact, I define financial wealth in years as (net worth / annual spending). That makes relatively conservative assumption that the portfolio keeps up with inflation and taxes. I heed the words of financial theorist and author William Bernstein who says, “When you’ve won the game, stop playing.” I don’t take risks I don’t need to take and recommend the same for my clients. I try to explain both the probabilities of bad returns and the consequences.
I spoke to Michael McDaniel, co-founder and chief investment officer at Riskalyze, which says it builds “fearless investors.” First, he stated that its survey is only a starting point. He agreed it did not address the need to take risk, but said its risk score is used by the advisor to then help the client to adjust the portfolio based on need.
McDaniel disagreed with me, however, that the risk score isn’t stable over time, telling me scores only dipped slightly and briefly during down markets like the end of 2018. He did acknowledge that they have only been tracking the scores since 2011, so it hasn’t been tested during a bear market or when markets declined by more than 50%, as has happened twice since 2000.
Read the full article here by Allan Roth, Advisor Perspective