In the July 2012 Regulatory Notice 12-25, Finra provides additional guidance on the issue of “suitability.”  Specifically, Finra states “a broker must have a reasonable basis to believe that a . . . investment strategy . . . is suitable for the particular customer based on the customer’s investment profile.”   They go on to specify “The new rule broadens the explicit list of customer-specific factors that firms . . . must attempt to obtain and analyze when making recommendations to customers.  The new rule adds a customer’s . . . risk tolerance to the explicit list of customer-specific factors . . .”

In response to this rule and its predecessors, the investment industry developed the so-called “risk tolerance questionnaire”  --  a short set of multiple-choice questions that the retail investor is required to answer. The results are then numerically scored and generally summarized as a single number, which the advisor or financial planner uses as the client’s specific risk tolerance. For example, you have a risk tolerance of “2” therefore you are conservative, while I have a risk tolerance of “8,” therefore I am aggressive.  Advisors who rely on such an approach then select the portfolio lying on the efficient frontier that corresponds to their risk tolerance number. Simple, straightforward, and fully documented.  Unfortunately, there are a few problems with this approach.

Failings Of Risk Tolerance Questionnaires

Academic economists have a long history of building abstract, simplified models of consumer and investment markets and their associated behaviors.  In such theoretical models, academics assume that consumers (investors) base their individual decisions on simple utility functions (these are short algebraic equations that are then maximized in order to determine what specific decision a consumer will make with respect to each choice).  Utility functions have a single variable sometimes referred to as the function’s risk tolerance.  Such simple academic models are extremely powerful when applied in university research settings designed to grow our theoretical understandings. Unfortunately, when applied incorrectly to the wrong situations, i.e., when applied to complex real world settings, they frequently misguide and deliver poor solutions.  FINRA’s mandate to identify a client’s risk tolerance is effectively based upon this academic, over-simplification of the real world.  Several significant problems exist. 

Today, it is widely appreciated that risk tolerance is not a clean, crisp economic factor, unique to each rational economic-person.  Instead, it is understood to be a fundamental psychological trait as observed by Dr. Geoff Davey in the October 2012 Investments & Wealth Monitor. As a psychological trait, it is inconstant, nondurable, and ever-changing. Worse yet, it has proven to be highly path-dependent.  In other words, how one scores on a risk tolerance questionnaire will depend heavily on the recent investment market returns and volatility experienced by the investor. In essence, risk tolerance questionnaires are heavily emotion-driven.  As one set of academic researchers (Drs. Lucarelli, Brighetti, and Uberti) observed “Emotions are confirmed to drive the financial risk-taking process, enhancing the accuracy of the individual risk tolerance forecasting activity.”

Worse yet, research by the London office of Barclays Wealth Management on decision-making processes used by consumers and investors recognizes that risk is not a one-dimensional attribute (as assumed by risk tolerance questionnaires), but instead entails a complex and unstable multi-dimensional array of factors.  This multi-dimensional attribute all but dooms risk tolerance questionnaires to the irrelevant (at best) or the misleading (at worst). 

Consider for a moment one of the most carefully developed tests of the last century.  The Scholastic Aptitude Test (SAT) has been given to high school students since its first introduction in 1926.  Over the last 87 years its veracity has improved significantly.  Each year, refinements have been made to the test.  Major advances in psychometric test construction and test scoring and the results of many tens of millions of test taker results have been used to refine the SAT exam.  Nevertheless, despite its extensive four-hour length and its near-century of refinement, it remains a terrible predictor of college success.  SAT scores and college grades correlate at around 0.4  --  a terrible outcome, observed Dr. Geoff Davey.  Consider then, what chance a simple risk tolerance questionnaire, to be completed within three or four minutes, has in identifying a fundamentally multi-dimensional psychological attribute that has been intentionally misspecified as one-dimensional. Risk tolerance questionnaires are a direct and immediate disservice to our very genuine need to best meet our client investor needs. 

As one team of researchers (Drs. Lucarelli, Brighetti, and Uberti) examining risk tolerance questionnaires observed “Our findings show that misclassifications resulting from the questionnaire are massive:  individuals asked to self-assess their risk tolerance reveal a high probability of failing their judgment, i.e., they behave as if they were risk takers, while defining themselves as risk-averse (and vice versa).”  But the instability and over-simplification of risk tolerance questionnaires is only the tip of the iceberg.  Worse yet, they serve little purpose other than meeting regulatory mandates.  Consider three simple examples where reliance on risk tolerance questionnaires for the setting of asset mix results in failed financial journeys.

Failure no. 1.  I have $1 million in savings, have just retired at age 65, expect to live for 25 more years, and require an annual income of $80,000 (adjusted for inflation with the passage of time).  My risk tolerance questionnaire provides a score of “2” on a ten-point scale. Therefore I am placed in a conservative portfolio with an allocation of 10 percent stocks and 90 percent bonds. This portfolio is expected to provide a 1 percent real return over the next 25 years. Obviously, I will run out of money well before I pass away. Moreover, I could have prudently and safely taken on considerably more risk. If I had taken on more risk, my initial $1 million of savings should, with a very high probability of success, more than adequately meet my annual income requirements  --  resulting in a far more satisfying financial journey during my retirement years.  But reliance on risk tolerance prevented me.

Failure no. 2.  I have $10 million in savings, have just retired at age 65, expect to live for 25 more years, require an annual income of $150,000 (adjusted for inflation with the passage of time), and strongly prefer no end-of-life legacy. My risk tolerance questionnaire provides a score of “7” on a ten-point scale. Therefore, I am placed in a moderately-aggressive portfolio with an allocation of 70 percent stocks and 30 percent bonds. This portfolio is expected to provide a 5 percent real return over the next 25 years. Clearly, I will end up with a huge, undesired surplus at the end of my life (recall that I had a strong preference to leave no legacy). I would have experienced a far more satisfying and rewarding financial journey if I had adopted a higher spending rate and/or a significantly more conservative portfolio (allowing for increased surety).  Once again, reliance on the results of a risk tolerance questionnaire prevented me from following the more satisfying and rewarding path.

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