The Best Risk Tolerance Test Ever

It is a challenge for advisors to accurately measure clients’ risk tolerance level. Currently, advisors often ask a few risk questions in addition to the classic trio – age, income, and assets, to assess the clients’ risk tolerance level.

These risk questions generally fall into two categories.

In the first category, clients are asked how they would feel or act in certain scenarios. As a result, the client is put into a risk bucket such as conservative, moderate or aggressive. Dani Fava from TD Ameritrade pointed out in an article that people tend to answer in a way that makes them look good. Furthermore, people’ risk aptitude for the long-term usually differs from how they actually respond during the market upheavals.

In the second category, the clients are presented with a set of risk and return trade-offs to choose from, and the result is mapped to a risk tolerance number, in the scale of 1-100. Sounds great, but what maps to 100? Should it be the 30-year average volatility of the most aggressive model portfolio or the highest point of volatility during the financial crisis?

To solve these problems, our patent-pending Risk Tolerance Test boasts a unique design to bring unprecedented transparency and clarity. Using real upsides and downsides of real model portfolios, it sets up a realistic scenario to elicit an accurate response.

Each bar represents a model portfolio, from the most conservative to the most aggressive. The green part is the upside and the red downside.
The calculation is based on long-term average risk and return of the model portfolios, for a given investment amount, timeframe (6-month or 1-year) and confidence interval.

The client simply chooses a model portfolio that he or she is most comfortable with.

In this example, the client feels most comfortable with a potential upside of 14% at the risk of a potential downside of 6%, hence choosing the bar in the middle.

And the result directly maps to a target volatility level and a model portfolio.

This Risk Tolerance Test takes care of the long term risk aptitude. What about clients’ behavior when facing market upheavals? Our mini-surveys come in handy.

Based on research from MIT, our Investor Temperament survey asks three questions:

  1. What would you do if the S&P 500 declined 10% in the past 6 months?
  2. What would you do if the S&P 500 rose 10% in the past 6 months?
  3. Around what time during the Financial Crisis of 2007-2009 did you significantly decrease your allocation to stocks in your investment portfolio?

Research indicates that 51% of individual investors are passive investors. Trend followers and contrarians are also common.

Combining the risk questionnaires with the Risk Tolerance Test, advisors can have a holistic risk profile of their clients.

By J. Helen Yang, CFA

The Best Risk Tolerance Test Ever

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