BACK OFFICE HEROES: Risk Tolerance – What is Actually Being Measured?

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The Roman arch is one of the most enduring physical human creations—Europe, Africa and Asia are dotted with aqueducts, coliseums, theaters, temples and triumphal arches that have stood for more than a millennium—and every one of these arches is supported by a single keystone.

The keystone of financial planning may very well be a client’s risk tolerance, said Richard Thoeny, Executive Vice President of Product Strategy at PreciseFP.

Most wealth management firms measure and use risk tolerance as part of their process using Docupace’s PreciseFP platform, or another industry competitor—but what are they actually measuring?

“I think about risk tolerance not differently from the rest of the industry, but in the context of some of the other components that go into financial planning, and then also, I think of it from a compliance standpoint,” said Thoeny. “Risk tolerance, put simply, is the amount of financial pain and suffering a person can handle before they get really anxious with their investments moving in the wrong direction, or, also, it’s how much excitement they get when investments move in the right direction. How do you measure that? That’s risk tolerance.”

Risk tolerance is really just one piece of the puzzle for portfolio construction, said Thoeny, as other elements, like an investor’s age, wealth and time horizon, should also come into play.

In investing, time horizon describes the period of time before the investor needs or wants the capital they are allocating back—in most financial planning, time horizon is defined by retirement and longevity, or when an investor will need to start drawing income from their portfolio and the length of time that they will need that income stream.

“You also have things that impact people personally,” said Thoeny, like life events and sudden shocks that change their perceptions of financial comfort, health or aging. “It can ebb and flow, and for some people, risk tolerance can shift pretty significantly.”

How Do We Know It’s Meaningful

Most advisors would probably agree that knowing how their client feels about risk is important to creating a plan and a portfolio—but they might wonder whether the number or recommendation that is delivered as a result of going through a risk tolerance discovery process is actually meaningful.

Thoeny said that most common measures of risk tolerance have academic backing that links the questions they ask to a meaningful result that can be used to guide an advisor’s work.

“For example, we use the Lytton-Grable version of risk tolerance,” said Thoeny. “In 1999, Ruth Lytton and John Grable came out with their version of risk tolerance that has become a widely cited calculation for risk tolerance numbers.”

The Grable and Lytton risk tolerance scale uses 13 responses to create a quantitative measure of an investor’s stance towards investment risk, personal risk comfort and investment experience, and emotional resilience to speculative risk. In academic studies, aggregated responses to the Grable and Lytton measure create a normalized curve—a plot where responses cluster around an average measure of risk tolerance with narrow tails towards extreme aversion and extreme attraction to risk.

There are other methods for measuring risk tolerance, said Thoeny. Many of the users of Docupace’s PreciseFP platform modify the Lytton-Grable questionnaire and scale to come up with their own method and measure of risk tolerance.

Why Risk Tolerance

There are three main reasons to measure risk tolerance, said Thoeny: To align a plan and portfolio with financial goals, to meet compliance obligations and to behaviorally manage client relationships and portfolios.

“Measuring risk tolerance helps you align a plan and a portfolio with financial goals,” said Thoeny. “Understanding risk tolerance allows investors to align their investment choices. There’s a compliance component, too, in building out portfolios. It provides cover for the advisor and the firm when making recommendations. How can you justify a recommendation and prove your rationale for why you built a specific portfolio? It’s one of the components that you take into consideration, like age, time horizon and the amount of assets. Risk tolerance is a huge factor in suitability.”

Risk tolerance also helps to align investor expectations with the portfolio, and help the advisor manage the emotional stress of the investor, said Thoeny.

Risk tolerance acts as a link and balance between behavioral finance and the more technical realm of investment management and portfolio construction. The more risk tolerance is considered in portfolio construction, theoretically, the less behavioral management is needed on the part of the financial advisor—the portfolio is built so as not to stress the asset owner. The less risk tolerance, the more a financial advisor’s personal intervention might be needed to prevent the investor from panicking—or succumbing to speculative zeal–and making rash investment decisions.

“Advisors are going out and saying ‘let’s measure your risk tolerance and have a conversation around it,’ it’s a useful conversation started that’s all before you get to the portfolio and the investment side of things,” but it moves you towards portfolio construction nonetheless, said Thoeny. “It’s actually a nice way to have conversations that might otherwise be uncomfortable.”

While some investors recoil from talking about their feelings around risk, measuring and discussing risk tolerance means avoiding having these conversations in the middle of a market event.

“Let’s say the market goes down 20%,” said Thoeny. “That’s when you get the calls, and you can say ‘look, here’s what you said your risk tolerance was the last time we measured it, maybe it’s time to re-evaluate or rethink this,’ it’s another way to manage emotional stress and it does help to build trust because what the advisor is building is based on what the client has told them and agreed to: this is how they think about the world and their exposure to the markets.”

At minimum, advisors should revisit a client’s risk tolerance annually—Thoeny recommends doing so at the annual review.

The dangers of not measuring risk tolerance include missing the mark with a plan or portfolio, said Thoeny.

“Even worse, though, is that you’ve got liability exposure,” said Thoeny. “You have a fiduciary responsibility to that investor. Honestly, you’re also doing yourself a disservice if you don’t understand risk tolerance for every investor. It can play such an important role in portfolio construction. You risk ruining the relationship with that client if you don’t understand how they feel about taking on risk. My guess is that if you don’t understand a client’s risk tolerance you’re not going to have that client for very long.”


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