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Why You Should (And Shouldn’t) Use A Risk Tolerance Questionnaire

Risk Tolerance Question MarkAll financial advisors collect Know Your Client (KYC) information about their clients. Not only is it a regulatory requirement, it’s good business. It helps you build a winning investment approach by requiring you to collect your clients vitals.

History Of Risk Questionnaires

Unfortunately, as KYC requirements expanded in the 90’s and 2000’s advisors increasingly had to use ineffective, boilerplate risk questionnaires to meet regulatory requirements. A robust and widely available approach did not exist. This gave risk questionnaires a bad reputation. Advisors did not want to use a tool that was ineffective just to please the regulators but they had no choice. It was that, or go out of business.

Due to the forced regulatory antecedents of risk questionnaires some advisors chose to avoid as much as possible. But times have changed and we now have comprehensive risk profile questionnaires that are effective, compliant and measure more than risk tolerance (they can measure risk capacity, and goals). Below I explain why you should use a risk profile questionnaire. However, it wouldn’t be fair to talk about “why you should” without looking at the opposite, “why you shouldn’t”.

Why You Should Use A Risk Questionnaire

1. To Better Understand Your Prospects And Clients, So You Can Recommend Great Investments 

There has been an explosion in psychological and economic research about decision making since the late 90’s, culminating in Daniel Kahneman winning the 2002 Nobel Prize In Economics. This research and others has taught us how people make decisions.

We’ve learnt that people suffer losses more than they enjoy gains or that people have a tendency to follow the crowd and chase returns. This was not widely documented 10 years ago. We can use this information to design a questionnaire that taps into what clients want, need and how they will react during a market correction. This data will help you build a winning investment approach for your clients.

Additionally, one study found that advisors who use traditional conversational interviews to assess risk tolerance are only 40% accurate. 60% of the time, advisors are wrong about their clients’ risk tolerance. As Michael Kitces, the well-known financial planning blogger stated “a well-designed RTQ [risk tolerance questionnaire] is actually far more effective than an advisor’s professional (but highly subjective and potentially-business-model-biased) judgment“.

2. Company Efficiency

Having a standardized process for prospecting, on-boarding new clients and completing annual reviews will save you and your company mountains of time. If your firm uses a paper based questionnaire then going online will make your life incredibly easier.

I was recently speaking to a Pocket Risk customer who said switching to a comprehensive online risk questionnaire saves her company at least a few thousand dollars a year in employee time, filling and mailing costs.

3. Risk Profiling Compliance

The compliance burden for advisors is only going one way. Up! Regulatory agencies in Canada and the UK have become increasingly prescriptive about the need to assess a client’s risk tolerance, risk capacity and goals. The US, Australia and India are not far behind. Furthermore, especially in the U.S., regulators have been increasingly fining firms and expelling individuals for suitability failures. Last year there were $18,300,000 in fines. With the new Department of Labor Fiduciary Rule, more are likely to come for those who fail to accurately assess their clients’ risk profile.

Why You Should Not Use A Risk Questionnaire

Since I considered the argument for using a risk questionnaire, lets consider the reverse. The most common reason for not using a risk questionnaire is fear of documentation.

If you are afraid of documenting your clients’ wishes then it must be because you’re worried facts might be misconstrued and used to file a complaint against your firm. That is a legitimate concern and a valid reason for not using a risk questionnaire. However, we believe the solution to this problem is not to leave a vacuum of information but to…

  1. Only work with clients who demonstrate integrity. Avoid litigious individuals. No matter the facts, certain types of people will always sue you if something goes wrong.
  2. Use documentation to protect you by ensuring there are no “grey areas” to be misconstrued. Get your clients to sign off on your decisions. A vacuum of information leaves more open to debate.
  3. Use tools and services that comply with the letter of the regulations and their spirit.


If a risk questionnaire is effective and compliant then all advisors should use them. Evidence shows that the conversational interviews to assess risk are wrong 60% of the time. So if you want to recommend the best possible investment approach for your prospects and clients, it makes sense to use a comprehensive risk profile questionnaire.

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.

Is An All Cash Emergency Fund Stupid? Academics Say Yes!

 Cash Emergency FundSeptember’s Journal of Financial Planning has a controversial article about emergency cash funds.  Titled “Is an All Cash Emergency Fund Strategy Appropriate for All Investors?” the paper argues that a 6-month cash emergency fund comes with an “exorbitant opportunity cost” resulting in lower levels of wealth at retirement.

It’s become a sort of dictum that you should save at least 3-6 months of monthly expenses in case of emergencies. It’s the kind of advice people instinctively agree with and follow. The authors tear down this cornerstone of financial prudence and provide an impressive argument for a change in thinking.

First Things First

The authors begin their argument by invoking utility theory, which simply states investors should seek to maximize returns while minimizing volatility. Too often investors use “mental accounting” and see their wealth in buckets when they should be focused on the total portfolio. If for example they complete a risk tolerance quiz and they are shown to have a high-risk tolerance then they should apply a similar level of risk to their emergency fund.

The authors do add some important caveats. A more aggressive emergency fund should only apply to people in the “accumulation phase” of wealth building rather than those in retirement.

Secondly, it should apply to “more affluent” clients of financial advisors rather than the average Joe. I accept the first caveat but I feel the second is a little strict. Their analysis and insight can apply to people further down the income scale.

Before jumping into the reasons why an all cash emergency fund might be sub-optimal it’s necessary to state its purpose. The authors see emergency funds as having two main goals. Protect against “income shocks” (unemployment) and savings for future consumption. It is with this definition that they question what has become commonplace financial planning.

1. Insurance – The authors point to the myriad of insurance products that can protect people from income shocks. We have income protection insurance, incapacity insurance, mortgage protection insurance and many others that would soften the blow of any unemployment period. The risk of loosing a job and being unable to survive is slim given the range of products that exist.

2. Diversification – For those who want to invest their emergency fund in more volatile assets they can diversify some of their risk and see greatly improved returns. People tend to invest emergency funds in cash because it’s safe however, that does not mean investing in stocks for example is unsafe. The risk can be reduced.

3. Human Capital – The authors suggest that investors neglect to evaluate their human capital when making investment decisions. For example a college professor is likely to have a high degree of job security and could probably afford to take more risk with their emergency fund than a stockbroker. Certain jobs are safer and certain people are highly employable. If you fit into one of these categories then a more aggressive emergency fund could be appropriate to maximize utility.

4. MAIN ARGUMENT – Opportunity Cost – To conclude their argument the authors created a model to calculate how much wealth a person would loose by not investing their emergency funds into stocks and bonds. They took an example of someone working from age 25 to 65 assuming average levels of unemployment. Stock and bond data ran from 1926 to 2011.

The results were staggering.  If an individual invested their 6-month emergency fund in a 60/40 portfolio instead of cash they could expect to have up to 20% extra in retirement savings. This clearly calls into question the requirement for a 6-month emergency cash fund given the assumption you want to maximize returns. The question investors need to ask themselves is whether the peace of mind of having cash in the bank, is worth loosing up to 20% of potential retirement savings.

Emergency Cash

Concluding Thoughts

The authors make a compelling argument against the 6-month emergency cash fund. However, beyond a client’s risk tolerance and the possible use of a risk tolerance questionnaire they didn’t look at other risks. Notably, counter party risk (getting access to your insurance or investment from a provider).

Utility theory might tell us what is optimal but it fails to account for the behavioral psychology aspect of the human mind when it comes to investing. Regardless, the authors have made a compelling argument and if they can’t get investors to entirely drop the 6-month emergency cash fund I am sure more than a few would consider switching to three months.

Is it time for you to trash Modern Portfolio Theory?

Modern Portfolio Theory (MPT) needs little introduction. Developed by Nobel Prize winning economist Harry Markowitz in 1952, the theory forms the basis of portfolio construction for large swathes of the money management industry. MPT is an approach to how you can optimize returns for a given level of risk. Choosing a selection of assets that form an efficient frontier.  See the diagram below.

Modern Portfolio Theory

Despite its popularity the approach has come under attack largely due to the 2008/2009 financial crisis. The hallowed 60/40 stock bond portfolio saw losses close to 15%. While those with an 80/20 mix lost a quarter of their money.  The fact is MPT based portfolios performed exactly as intended during the crisis, optimizing returns for a given level of risk (volatility). What the crisis did however is open up a debate about the effectiveness of the theory. This leaves you with a fundamental question. Is it time to trash Modern Portfolio Theory?

Risk Is Not Volatility

In his 2011 paper “Is Portfolio Theory Harming Your Portfolio” Scott Vincent starts with something all money mangers implicitly understand. “Risk is in the eye of the beholder”.  MPT defines risk as variance from the mean (volatility).  As JJ Abodeely noted in his excellent blog post about the failings of MPT, Harry Markowitz chose volatility because it was “mathematically elegant” and “computationally simple”.

What does this mean for you? It means choosing a portfolio that provides an appropriate amount of risk and return depends heavily on how you define risk. For some clients capital preservation (downside risk) is a lot more important than variance (keeping up with the long run average).  If this is the case for your clients then it might be time to trash MPT.

Some of the advisors I speak to would call this a mute point. What matters is a client’s goals then you construct the portfolio to get you there taking an appropriate amount of risk. However, notice how risk still needs to be considered regardless of whether a client’s goals are the first step in portfolio construction.

Enter Post-Modern Portfolio Theory (PMPT). PMPT measures risk by looking at the downside. Essentially, how bad are the bad times rather than simply how are the times on average (MPT).  The theory can then be used to construct a portfolio that has limited downside yet meets the required goals of your client. The result is often portfolios that look wacky at first (e.g. The Permanent Portfolio) but deliver results. Take a look at the portfolio below for an example proposed by Unified Trust that has a historical return of 11.54% with a downside deviation of 2.2%.


The problem with such a portfolio is that it flies in the face of conventional wisdom. If advisors are to trash MPT and switch to something like PMPT they need to be brave. MPT has Nobel prizes and decades of support. Inertia is on its side. It would take a brave advisor to recommend the portfolio above and stick with it when the markets (and the wider investing community) favor a traditional 60/40 stock bond portfolio. If it’s true that downside risk is your client’s biggest concern and you are targeting a 8-10% average annual return then using PMPT and trashing MPT must be the way to go.

Historical Performance Is No Guarantee Of Future Returns

Practically every financial product comes with this boilerplate warning.  “Historical performance is no guarantee of future returns”. Yet MPT relies heavily on back testing to justify its position. The cornerstone of this back testing is using the historical correlations between asset classes to choose a diversified portfolio.  The table below from Wealthfront outlines the correlations between different asset classes.

 Screen Shot 2013-09-19 at 2.32.09 PM

The problem with using historical correlations to inform your decision-making is that correlations change. Stocks and bonds may have been uncorrelated yesterday but that doesn’t mean they will be tomorrow. Furthermore, during wars or a general market collapse various asset classes can move in sync canceling out any diversification.

So what does this mean for you as an advisor? It means we cannot simply rely on historical correlations to justify an asset allocation. We have to exercise some judgment. Use historical correlations as one weapon in your arsenal but do not base your entire strategy on it.

 What Next After Modern Portfolio Theory?

It’s clear that MPT has some serious flaws. Its definition of risk is questionable and it relies too heavily on back testing to justify its existence. That being said I don’t believe we should embrace market timing either.

Post Modern Portfolio Theory sets us on the right track by having a realistic definition of risk. Taking this definition we can find an asset allocation that minimizes downside risk yet yields a healthy average annual return. We just have to make sure it is a portfolio that minimizes costs, is easy to manage and has reason for its construction beyond historical performance.

3 Challenges Financial Advisors Face When Discovering Their Client’s Risk Tolerance

I just spent the last 10 weeks interviewing 76 financial advisors across the U.S. I asked them about their risk tolerance process. Specifically, how they discover the right level of investment risk for their clients.  The results were varied but the challenges were the same.

Firstly, advisors were struggling to balance the investment needs of their clients with their risk tolerance. Secondly, they were often happy with their discussion process but thought it could have more rigor. Finally, compliance was a common complaint but not in the way you would expect.  Let’s dig in and unpack some of these challenges.

1. Balancing Your Client’s Financial Needs With Their Risk Tolerance.

7272% of the advisors I spoke to first calculated their client’s financial needs before considering their client’s risk tolerance. Their role was often to ensure a client had enough money for retirement. This could necessitate an asset allocation with more volatility than a client could stomach but was necessary to ensure they met their future income goals.

At this point some advisors would say to me…“What is the point of a risk tolerance questionnaire if I am just going to invest based on need? Isn’t this simply a case of CYA (covering your ass)?” At which point I would draw on the experience of other advisors I had spoken to who had lost clients during the 2008 financial crisis. They regretted not having a thorough understanding of a client’s risk tolerance before the crisis. Since they didn’t know their clients intimately, they were unable to set expectations and manage them through the downturn.

As has been well documented, investment risk is a mix of tolerance, need and capacity and all of these have to be considered when developing an investment portfolio. Getting the balance right is a challenge for advisors but ignoring one of these factors does not solve the financial planning process.

2. Face-to-Face Client Discussion

A risk tolerance questionnaire alone cannot solve the investment process. Even if it could clients don’t want to feel like a widget on the production line. Advisors are wise to this and enjoy the process of an open-ended discussion with their clients. This is where you can build a relationship and capture details boilerplate questionnaires cannot.

However, an open-ended discussion process in a firm of multiple advisors can often lead to a lack of consistency and objectivity. One advisor admitted to me that if one of his employees left the company they would loose detailed knowledge about their client’s investment preferences because it was all in his head. A scary thought.

78% of the advisors I spoke to admitted that they could probably improve their record keeping and make it more systematic. A few advisors recorded their discussions on a dictaphone or used mind mapping software but the majority resorted to scribbling notes on paper while their client did the talking.

3. Compliance

Given the litigious culture we find ourselves in, it’s not a surprise that advisors are afraid of lawsuits. Amazingly, I found 9 of the 76 advisors were afraid of too much documentation in case it was used against them in a lawsuit. Sure, they wanted to understand their client’s risk tolerance but they didn’t want too much evidence of it!

The majority however, appreciated that meeting regulatory demands and keeping accurate records would most likely protect them from lawsuits and not the other way around.

Solving These Challenges

At first thought there are clearly a few things that can be done.  For example using a robust risk tolerance questionnaire, having a clear and consistent on boarding process for new clients and keeping full and accurate records. But this is just the start. Over the next few days, weeks and months I will be tackling these challenges on this blog. Please subscribe on the right for future email updates and share this blog with your friends if you liked it.