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There's an increasing interest in risk profiling around the globe. We now have several competitors. Many new risk profile providers must feel obliged to provide a new insight that shows their research revealing established views (often FinaMetrica's views based on our almost 20 years and over million test experience) as wrong. Unfortunately their conclusions can be based on flawed thinking or flawed inputs. This is a recent example, and our response, raised by a Sydney based subscriber.
“I was at the Morningstar conference and a presenter commented along the lines that: "...the value of risk tolerance profiling is questionable at best because research shows that clients with a high risk tolerance don't behave accordingly. Clients with a low risk score are the ones that stay the course (according to what their profiling questionnaire revealed)". To this point then I am interested to know if you have any research that shows the percentage of clients that behave differently to what their profile suggests.”
We are not at all surprised by the Morningstar research as we have reservations about the outputs of their risk profiling. In particular, their risk profile appears to ask a combination of risk tolerance, risk capacity, time horizon and experience questions (a combination of psychological and financial questions).
It is well documented that psychological and financial attributes cannot be assessed together, they need to be separated and then mapped to a common parameter so that informed trade-offs can be made. If they are assessed together then the result is an average that is not at all useful to the client or advisor. Here's a simplistic example, someone with a long time horizon and a low risk tolerance will be given the same outcome as someone with a short time horizon and a high risk tolerance and we know that these two clients require different strategies.
Furthermore, many (as seen by Morningstar) often mistakenly “equate” risk tolerance with risk behaviour and interpret changed risk behaviour as changed risk tolerance.
Just because someone’s behaviour has changed doesn’t mean that their risk tolerance has changed. Behaviour in risky situations will not be a function of risk tolerance alone. Goals, the perceived risk, the perceived alternatives, the level of trust in an advisor if one is involved, etc. will all play a part. We know that risk tolerance is stable - even through a Bear market (see reference below). When behaviour changed in the last Bear market, it was much more likely to be because perceptions of risk had changed. Clients (and many advisors) simply had no idea that what did happen could happen. Perceptions of risk can change in an instant. Questioning advisors who say that their clients’ risk tolerance has changed usually leads to their agreeing that this view is an assumption based on observed behavioural change.
A more likely explanation of why people may not stay the course is that risks and trade-offs were not properly assessed and explained and you have a miss-match. That is, the questionnaire used is not reliable or accurate and the risks in the product is not properly explained and people are surprised. When people are surprised they react accordingly, as described by Robert Kiddell during the 07 bear market.
"Our practice is divided into two teams – ours uses FinaMetrica, the other does not. Our team has observed FinaMetrica's worth because our team's clients stayed in their seats for the 2007-09 rollercoaster ride, whereas a number of the other team's clients have abandoned their seats at or near the bottom."
Robert Kiddell CFP
McMillan Financial Planning Pty Ltd
The FinaMetrica lexicon of risk terms may be of value. It offers over 50 definitions, several of which are often used interchangeably, leading to poor communication.
http://www.riskprofiling.com/risklexicon
Reference: Roszkowski, M. & Davey, G. (2010). Risk Perception and Risk Tolerance Changes Attributable to the 2008 Economic Crisis: A Subtle but Critical Difference, Journal of Financial Service Professionals, July, 42-53.
Grable, John E., Wookjae Heo, and Michelle Kruger. 2016. “The Intertemporal Persistence of Risk Tolerance Scores.” Journal of Financial Planning 29 (8): 42–51.
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