Category Archives: Risk Tolerance

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.

3 Things Your Clients Must Understand Before You Assess Their Risk Tolerance

I recently had a discussion on Facebook with two financial advisors about risk tolerance questionnaires. The advisors expressed their frustrations with managing client behaviour. In one advisor’s words “there is an emotional element that is difficult to quantify” in questionnaires. Pocket Risk helps here but we agreed a certain level of client education is necessary to ensure people “stay the course”.

The academic and practice literature supports this. The University of Michigan’s Health and Retirement Study has shown that people with lower levels of education are less likely to take investment risk. This means they are at risk of forgoing the gains in holding equities and missing their retirement goals. Practice professionals such as Harold Evensky in his book “The New Wealth Management” have stressed the importance of client education before building a financial plan and investing.

So what do your clients need to know?

1. Your Clients Must Understand The Risk-Return Trade-off

In order to be comfortable with risk your clients need to understand what risks they are taking. At the beginning they should understand the risk return trade-off. That is the idea that as an investor you are expected to get higher returns for taking more risk.

Here is a real life example you can share with your clients. In 2004 Google IPO’ed and became a public company. The shares traded at $54 (accounting for stock splits). There was a lot of uncertainty about the company’s business model and investors were largely reluctant to invest because of the dot com collapse four years earlier. Most investors did not want to take the risk.

However, today, Google’s shares have been trading at over $750 per share. Those investors who were willing to take the risk (on a company that was eventually very successful) have received high returns. This is how the risk-return tradeoff works in action.

Conversely, people who invested in Twitter which IPO’ed in 2013 at $41 have seen their value drop to $18 dollars. These investors took a risk most people were not willing to make and they lost money.

Your clients should know, that if they wish to make more money they are probably risking greater losses.

2. Your Clients Must Understand Time Horizon
Your clients should appreciate that assets can go up and down in value but over the long term they have a trend. In the short term (0-3 years) volatility can be wild but over longer periods of time there tends to be a pattern. Therefore, the longer you invest the more certain you can be about how much money you will make.

Below is a real life example you can share with your clients with historical returns of the MSCI World Stock Market Index 1970-2015 (dividends reinvested, before fees and taxes).  This diagram shows your clients that investing over a longer time period means less chance of loss.

By jumping in and out of investments when assets drop in value, they will likely miss the gains on the upside. As proven by Geoffrey Friesen and Travis Sapp in their paper – Mutual fund flows and investor returns: An empirical examination of fund investor timing ability – 2007. We recommend you use diagrams like the below to explain key concepts to clients.

Risk Tolerance Client Education Time Horizon


3. Your Clients Must Become Comfortable With Uncertainty

Once your clients understand the risk return trade-off and the importance of time horizon there is one last thing they must understand…

Sometimes great plans don’t hit the mark. There is a luck factor in everything that we do as humans. Your clients must understand there is no certainty in investing. However, we can use probabilities to increase our chances of achieving our goals.

Communicating this to clients can be difficult. They are paying you for results and you have to explain to them why there is a small chance you won’t deliver.

But if you use simple analogies, it can be explained. For example there is a high probability of getting into a car accident if you run red lights. There is a low probability if you follow all the rules but you can still get into an accident. It’s your job to explain how you will increase the chances of them hitting their goals.

I recommend you read a book by Nick Murray called “Simple Wealth, Inevitable Wealth”. Focus on the epilogue titled “Optimism Is The Only Realism”. Nick Murray has been a financial advisor for 50 years and a coach to thousands of advisors over the last two decades.

He believes that the dominant determinant of long-term, real-life return is not investment performance but investor behavior. Second, that behavior modification ought to be an advisor’s true value proposition, because great behavioral advice is at critical moments in an investor’s life, worth so much more. I completely agree.

Making Pocket Risk More Mobile Friendly

Pocket Risk MobilePocket Risk is now more mobile friendly for clients completing the questionnaire. Clients can complete the online questionnaire on their mobile devices. This will allow people to complete the questionnaire on the go and avoid the need to use a desktop.

Previously it was was possible to complete the questionnaire on mobile devices but the experience was a little clunky. We’ve fixed that.

Please contact us if you have any questions.






3 Important Academic Studies About Risk Tolerance

Risk DiceUnderstanding risk tolerance should not be a guessing game especially when dozens of academic studies can point us in the right direction. Below is a list of important academic studies in the field of risk tolerance.

Financial risk tolerance revisited: the development of a risk assessment instrument  – John Grable and Ruth Lytton – 1999

Perhaps the most important paper on devising a risk tolerance questionnaire. Dr Grable and Dr Lytton bring scientific validation to the risk questionnaire through the use of validity and reliability testing. 

Link to paper

Measuring the Perception of Financial Risk Tolerance: A Tale of Two Measures – John Gilliam, Swarn Chatterjee and John Grable – 2010

This study compares the explanatory power of a simple question about risk versus a multi-dimensional 13-item questionnaire when trying to understand someone’s risk tolerance. Unsurprisingly the multi-dimensional questionnaire showed better results. The research helps explain why advisors should not be using boilerplate questionnaires.

Link to paper

Insights from Psychology and Psychometrics on Measuring Risk Tolerance – Michael Roszkowski, Geoff Davey, John Grable – 2005

This paper re-enforces previous studies that show risk tolerance can be measured as long as the questionnaire is long enough and asks good questions (doesn’t mix in questions about risk capacity and risk needs).

Link to paper

If you want to know more about the academic study of risk tolerance please add a comment.

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Morningstar Risk Tolerance Questionnaire – The Good and the Bad

Morningstar LogoThere are many risk questionnaires used by financial advisors and the most common appear to be bundled in with software an advisor is already using. Morningstar is a popular tool used by financial advisors for investment research and financial planning. I often get asked my opinion on the Morningstar risk tolerance questionnaire. So today, I am taking a deeper look at the good and the bad.

Click here to get the Morningstar Risk Questionnaire pdf

Morningstar Risk Questionnaire – Time Horizon

Morningstar 1

The Good

  • The good thing about the time horizon section is that the questionnaire is attempting to establish some sort of goal for the client by asking about their age and when they expect to start drawing income. That being said this is supposed to be a risk tolerance questionnaire not a collection of goals. How much risk someone is willing to take is not the only factor in determining someone’s goals. You also have to look at their needs and risk capacity.

The Bad

  • Age in itself is not a clear indicator of risk tolerance. It’s possible that someone who is older than 75 has a higher risk tolerance than someone who is less than 45.  There is dangerous assumption in the question that to be older is to be more conservative. This is not necessarily true and can result in younger people having overly aggressive portfolios and older people having portfolios that are too conservative.
  • The second question assumes the client wants to draw income. Again this is an assumption that may not be true for all clients. That being said most clients of financial advisors are looking to draw income at some stage so I think this question is fair.

Morningstar Risk Questionnaire – Long Term Goals and Expectations

Screen Shot 2014-11-19 at 10.34.12 AM

The Good

  • Again there is an emphasis on the client’s goals, which is good to know but I am left wondering if this is the right place to ask such a question. Are we trying to establish someone’s risk tolerance or their goals? These two factors often conflict.
  • Question five is interesting and speaks well to understanding a client’s expectations.

The Bad

  • Question three is ok but I wonder if the question covers all the goals a client could have. For example, a client could have different goals for different buckets of money. Or maybe they just want to meet their retirement needs but they have no idea if this requires aggressive growth or “to grow with caution”.
  • Question four is challenging because of the use of “normal market conditions”. What is normal? Is this the last year? 10 years? 50 years. Other than that, I like the answer options.

Morningstar Risk Questionnaire – Short Term Risk Attitudes

Screen Shot 2014-11-19 at 10.34.24 AM

The Good

  • I like question 7. Again, seeing how a client feels in the short run helps an advisor manage expectations.  The specificity of the third answer option (10%) makes it clear what type of loss we are talking about.

The Bad

  • Question six starts off good. I like the question. However, the answer options are too vague.  Someone may be comfortable with a “small loss” but what is a “small loss”? 1% 10%, 15% or more? It is unclear from the options resulting in the advisor having to make an assumption.


The Good

  • The questionnaire makes a decent effort at understanding client expectations and there is a fair attempt at understanding their goals.

The Bad

  • Frankly, this doesn’t appear to be a risk tolerance questionnaire it’s more of a hodgepodge of questions designed to understand the very basics about a client and it struggles to do that conclusively.
  • Too few questions. It’s unlikely that someone’s investing future can be determined by 7 questions.  There’s just not enough detail to make the final result reliable.
  • Where have these questions come from? Was there any science or academic research behind its development? Without this its accuracy can and will be questioned.

For those advisors who wish to go deeper with their clients and have a thorough understanding of their risk tolerance I would be a little cautious about the Morningstar risk questionnaire.  It’s basic and you would most likely need to ask many face-to-face questions on top to learn more about your client.

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