Category Archives: Managing Clients

You’re Using Your Risk Tolerance Questionnaire Wrong

Risk Tolerance QuestionnaireMost risk tolerance questionnaires get a bad rap. For many advisers, they are simply a compliance tool to appease the regulator. They add some value, but if it weren’t mandated, they probably wouldn’t use them. This negative mindset is rightly deserved due to the abusive use of risk questionnaires. Let’s get a few things straight…

  1. Risk questionnaires cannot tell you exactly how to invest.
  2. Risk questionnaires cannot cover the entire suitability process.
  3. Risk questionnaires cannot solely be used for prospecting.

The true purpose of a risk questionnaire is to help you know your client so you ask intelligent questions and recommend the best investments. Knowing your client entails understanding their goals, psychological risk tolerance, capacity for loss and behavioral biases. You cannot capture all of this in a questionnaire.

Investing should be goals driven but instead it’s compliance driven

Risk questionnaires should help you recommend investments and handhold clients during market ups and downs. Not prescribe allocations and securities. The FCA hinted this in their Financial Advice Market review published in March. A questionnaire cannot challenge a client’s misunderstandings or mistakes. This is what being an adviser is all about. Only you can do this.

The regulator has attempted to legislate trust between you and your clients but we know that’s impossible. It has resulted in the bizarre outcome where people are invested according to “what would pass an audit” instead of their long-term goals.

So what’s the solution? It’s twofold.

  1. Ultimately, the financial advice market will need to increase its standing in society so it has more trust and less need for regulation. Perhaps the greatest trust builder being increased education and professionalism across the ranks (which is happening). At the beginning of the last century medical doctors were widely decried for their quack cures and empty promises. A few decades later they were the most esteemed profession in the country. This can happen with financial advisers.
  1. On the risk tolerance questionnaire side, you should be ready to challenge the results of a risk questionnaire if it suits your clients’ greater long-term interest. Human judgment shouldn’t be completely dismissed. It just needs to be thought through and documented. Admittedly, going through a detailed question and answer session with a client is less efficient than a questionnaire but it will help you learn about your client’s overall profile in a way a risk questionnaire cannot.

As someone who leads a company that creates a risk tolerance questionnaire for advisers you might think it odd that I call out the limitations. On the contrary, I think this draws to attention the qualities and uses of an effective questionnaire. It should help you understand a client’s goals, psychological risk tolerance, capacity for loss and behavioral biases so you can ask intelligent questions and guide clients towards their goals. It should act as a client-friendly, 3rd party check in your process to ensure you don’t succumb to your own behavioral biases. Does your risk tolerance questionnaire do this?

Do Your Clients Want To Be Rich Or Avoid Poverty?

RichI was recently reviewing a list of psychological investment biases in a paper called “How Biases Affect Investor Behaviour” by H. Kent Baker and Victor Ricciardi and I realized something is missing from the bias canon. I call it the “Not knowing what you want bias”. My belief is that if your clients are unsure about what they want, they become wildly susceptible to all the biases mentioned in the paper above. A lack of focus drives them off course.

When I speak to advisors and ask them what their clients secretly want, they say “to get rich”. But investing to get rich is far different than investing for a comfortable retirement. This secret desire to get rich is what causes people to chase technology startups, biotech companies and non-traded REITS.

If a client’s stated goal is to have a comfortable retirement then they can probably reach it so long as they invest early and often through multiple decades. But if they want to get rich, they should look beyond the public stock market.

Counteracting this “get rich” desire can be accomplished by re-iterating the goal at every client meeting. Tell them again and again and again. Our goal is not to get rich, but to achieve a comfortable retirement.

If they inculcate the goal, they will eventually realize their retirement account is not for “getting rich” and will use their careers as the wealth creation engine.

Why It’s Not Enough To Know A Client’s Risk Tolerance

Dr. Robert Olsen

Dr. Robert Olsen – Author of “Investment Risk: The Experts’ Perspective”

It’s almost universally accepted by advisors and prescribed by regulators (e.g. FINRA, FCA, and MFDA) that advisors assess a client’s risk tolerance before recommending investments. Knowing how much risk someone is willing to take is essential in building a suitable plan. However, assessing someone’s risk tolerance is only one part of the puzzle.

Smart advisors assess other key client characteristics like goals and a client’s risk capacity (definitions here) but they should also assess a client’s ability to “stay the course”. Risk tolerance, risk capacity and goals are not enough.

Critiquing Risk Questionnaires

The number one critique of risk questionnaires is their inability to assess if a client will want to “sell at the bottom of a market correction”. This critique is largely unjustified because all risk questionnaires are not created equally. Those with robust underpinnings, rarely suffer this fate.

Additionally academic research has increasingly supported the idea of two psychological risk constructs. Risk tolerance is how much risk someone is willing to take based on objective outcomes and risk perception is the perceived risk of that decision. As Larrick said in his paper Motivational Factors In Decision Theories – 1993 – “it seems obvious that people’s preferences may depend not only on how they value objective outcomes but also on how they feel about risk.”

Risk perception explains why someone says they are willing to invest in an 80/20 stock bond portfolio and live through a 30% drawdown. But don’t want to do it in March 2009 at the bottom of the financial crisis. Their risk willingness is high, but their perception of the risk at that moment is also high because of the context of the decision.

What’s An Advisor To Do? 

New research is always being developed in this area but a well cited older paper from 1997 by Robert A. Olsen’s “Investment Risk: The Experts’ Perspective” should interest you.

Olsen surveyed a group of professional portfolio managers and wealthy individuals who managed their own account. He was attempting to discover the risk characteristics people most cared about when investing.

He learned people cared about four attributes:

  1. The potential for a large loss
  2. The potential for a below target return
  3. The feeling of control over an investment
  4. The investor’s perceived level of knowledge

Looking at Olsen’s results we can conclude high quality risk profile questionnaires will help advisors assess a client’s ability to stomach a large loss or deal with a below target return. However, most don’t do anything to give clients a sense of control or education.

If you want your clients to stay the course they must feel like they have control over their investments and they must be educated. You can’t simply use a risk questionnaire, apply the results and then stop discussing risk with your clients.

Giving clients control can be achieved by ensuring they have easy access to their accounts and transparency about objectives and performance. Education is best done at account opening and over time with a regular newsletter. 


In order to build a successful investment plan for your clients they need to stay the course as markets move up and down. If they are to stay the course you must not only know their risk tolerance, risk capacity and goals. You must also give them a sense of control over their investment fate and education. Education in particular is critical because it’s the best mechanism to stem the noise of the financial news media.

What Is Risk Profiling? Part 2: Let’s Stop Debating Definitions

In my previous article “What Is Risk Profiling – Part 1”, I showed how you can’t talk about risk profiling, without understanding risk. And that the definition of risk has changed over the centuries due to academic research and human experience.

The modern consensus is that risk is a mathematical and psychological construct.

This consensus is built on over 64 years of research. It starts with the mathematical Harry Markowitz and his followers who gave us Modern Portfolio Theory and the Capital Asset Pricing Model. Most recently Friesen and Sapp have added to the psychological by publishing mutual fund data showing that “investor underperformance due to poor timing” is consistent with “return-chasing behavior”. And return-chasing behavior is primarily driven by psychological biases and a lack of financial education.

So for financial advisors, risk profiling is the process of understanding your clients’ mathematical and psychological situation in order to give good advice. Take a look at the diagram below.  

What Is Risk Profiling

The mathematical and psychological situation of the client has been further broken down in order to translate into how financial advisors do their work. See diagram below.

Risk Need Risk Capacity Risk Tolerance Risk Perception

According to the Ontario Securities Commission who recently undertook a study into risk profiling and risk profile questionnaires, the terms are defined as follows.

“Risk Tolerance: The willingness of the client to take on risk. It can be defined through their attitude towards risk and is often described as a high/low risk tolerance.” Risk Tolerance is also regarded as the opposite of loss aversion. This is backed up by research from Rozkowski, Grable, Kahneman and Tversky.

“Risk Capacity: The financial ability of a client to endure any potential financial loss. Does the client have the financial ability and can they afford to take on the risk?” This is backed up by research from Hanna, Chen, Waller and Finke.

“Risk Need: Refers to the amount of risk that should be expected in order for a client to meet specific financial goals. Larger goals may require higher returns on investment that comes at the cost of higher risk.” This is backed up Markowitz and his followers.

“Risk Perception: A judgment that the client feels towards the severity of risk in association with the broader economic environment. This perception can be heavily influenced by the media and/or through lack of understanding of the risks. The influence of ‘risk perception’ and ambiguity aversion may be reduced by greater financial literacy, education or experience.” This is backed up by research from Friesen and Sapp.

Risk Composure: This is the likelihood that in a perceived crisis the client will behave fundamentally different to their rational self and may take action that could crystalize losses. It can be measured based on a client’s past decisions.

Risk Profile: The aggregate of all of these factors to arrive at an overall determination of a ‘sweet spot’ for a client, such that it maximizes their ability to achieve their goals but is consistent with the level of risk they are willing and can afford to take.

At Pocket Risk we agree with these definitions and the academic literature supports it.

These definitions are the culmination of decades of experiments by academics, the practical experience of advisors and increasingly the support of regulators in Canada, the UK, Australia, and India.

In order for advisors to best help their clients, they need clear definitions from regulators and the academic community. Now we have them, it’s time to build tools and practices that allow advisors to better serve their clients.

 If you have any thoughts on this article, I’d love to hear them.

What Is Risk Profiling? Part 1: Over 362 Years Of History

Risk profiling is the process of understanding how much risk is necessary for a client to achieve their financial goals.

But this only begs the question – What is risk?

The challenge for financial advisors is that the definition of risk keeps changing as research expands. In order to understand risk profiling, you have to start with the history of risk.

17th Century – Expected Value

Blaise PascalIn the 17th century Blaise Pascal (on the left) and Pierre de Fermat exchanged letters attempting to solve a mathematical puzzle and they gave us Expected Value. This is the idea that by multiplying the possible outcomes of an event by the likelihood of each outcome and summing those values we could know whether to proceed with a bet. Here is an example.

Imagine investing $50,000 in a biotech stock. You calculate your returns as…

90% chance the value drops by $25,000

10% chance the value increases by $300,000

The Expected Value = (0.9 * -$25,000) + (0.1 * +$300,000)

Expected Value = +$7,500

According to Expected Value, we should invest in the biotech stock because even though the odds are terrible, we have a positive expected value with a potentially huge payoff.

18th Century – Marginal Utility

In the 18th century Daniel Bernoulli rejected this approach and published an article stating, “The determination of the value of an item must not be based on the price, but rather on the utility it yields…. There is no doubt that a gain of one thousand ducats is more significant to the pauper than to a rich man though both gain the same amount.” – Exposition of a new theory on the measurement of risk – 1738

Essentially Bernoulli said risk depends on an individual’s circumstance not just the odds of a potential payout. His theory became known as Marginal Utility Theory and is closely linked to the modern idea of risk need.

20th CenturyVolatility

In the mid 20th century Harry Markowitz birthed Modern Portfolio Theory. Markowitz’s model defined risk as the variability of returns (also known as standard deviation). From the 1950’s to the early 2000’s risk has been primarily been measured in volatility.

Unfortunately, Markowitz’s ideas have been twisted. He clearly stated in his seminal work “Portfolio Selection – 1952” that his models were about “choice of portfolio” not about the “experience” of the investor. I doubt he would state that the primary risk to a financial plan is the variability of portfolio returns. He would say the primary risk is the investor making bad choices.

Starting in the 1970’s and gaining rapid attention today is the idea that risk is mathematical AND psychological construct.

21st Century Behavioral Finance 

In the last 30 years there has been an explosion of interest in risk. Look at the graph below from Google Books. It shows the popularity of the word “risk” in English language publications from 1700 to 2016. We are now 6x more likely to write about risk than God.

Behavioral finance led by Kahneman, Tversky, Thaler, Ariely, Rozkowski, Grable, Lytton, Finke and others shows us that risk lies in the actions of the investor not just security selection and financial planning. Psychological biases like anchoring, loss aversion and social proof demonstrate we are not rational utility maximizers. Risk is not volatility.

I’ll end Part 1 of this post by going back to definition set out earlier. I said, “Risk profiling is the process of understanding how much risk is necessary for a client to achieve their financial goals.“

Therefore, in order to understand how much risk is necessary for a client to achieve their financial goals you must understand the mathematical AND psychological situation of the client. You must know your client.

In Part 2 we will go into detail and discuss the mathematical and psychological elements of risk profiling.