• Call Us @ (905)731-9800

Risk Profile Review

Once in a while, whether markets are doing really well, or are going down, you should review your risk ranking level.

Risk Profile Questionnaires – They Could Be Dangerous For You

When meeting with a new client or at review time with an existing client, one of the first things that advisors are expected to do is have the client fill in a risk profile questionnairedetermine the current risk tolerance.

The key word here that we want to emphasize is "current."

These questionnaires try to determine how a client feels about risks and rewards in order for the advisor to recommend what percentage of the portfolio should be in risky asset classes like stock funds and what should be in conservative asset classes like bond funds.

But... we do not believe that this process adds any real, long term value as it really only measures how the client feels "now".

Think about this for a moment: How do you feel right after watching a well-done horror movie? Remember the original movie Psycho? How many of us did a double check just before we took a shower the next day?

Or did a double check just before we went swimming in the ocean after watching the movie Jaws?

What chance does a simple risk tolerance questionnaire, to be completed within three or four minutes, have in identifying a fundamentally multi-dimensional psychological attribute that has been intentionally mis-specified as one-dimensional? Clients should be told by their advisor that many risk questionnaires are mostly worthless if not done properly. Based on our own personal belief after over 30 years of actual experience we would say they are worse than that and actually could be dangerous to the client if not used properly.

The Possible Problems


Studies in behavioural finance show that investors would have answered risk questionnaires differently if they had taken it in January 1995, March 2009 or in 2014. This unstable view of risk tolerance is why, according to Morningstar, investors underperform not only the markets but also the actual investments that they buy by over 2.25% a year.

Questioning Traditional Approaches

We believe many questionnaires may be unreliable because many lack basic questions about investment behaviour and only focus on mathematical "risk-return equations only."

In a CFA Institute publication Building a Client's Risk Profile: Using Questionnaires to Develop Investment Policy, Karen Spero, an advocate for the use of questionnaires, admits that the answers from questionnaires "are often unreliable because many investors are inexperienced or misinformed."

Emotional Behaviour: Good & Bad

Emotions prevent us from being lost in thought when it is time to act, and emotions reinforce lessons we must learn.

Emotional benefits come with positive emotions such as exuberance, hope, or pride. The desire for the benefits of hope motivates lottery players to pay a dollar for lottery tickets that pay, on average, only 50 cents. And the desire for the benefits of hope motivates employees to accept stock options in place of salaries, even when, on average, stock options are worth less than foregone salaries. Negative emotions such as fear, sadness, and regret are unpleasant but often useful. Fear prompts us to slam on the brakes fast when the car in front of us suddenly stops, and sadness over a lost job guides us to slow down, reflect on our lives and careers.

Emotions also triggers fear when the markets are collapsing - our first instinct may be "to get out of the way." Emotions also triggers greed when the markets are rising - our first instinct may be "to get in while it is still hot".

Also, most questionnaires also ask about a rebalancing philosophy.

But the ability to rebalance properly is again impacted by one's current state of mind. Rebalancing properly during times when the market plunges (2008) is one of the hardest things investors will ever do. Data shows that most investors sold off equities in 2008 right up to 2011 and were investing more in cash or more in bonds at that time. Why? Buying more stock funds at those times for most will feel like getting punched in the gut. We just want the pain (of losing money) to stop so we act to stop what is causing us the pain. The real purpose of a good questionnaire and defining risk is to make sure that you have a plan that meets both your current needs and future needs. Therefore to do a really good job in planning, an investor should probably complete a risk questionnaire every four years to five years.

Why?

Maybe the first risk questionnaire you did was in the middle of the tech boom in the 1990s and you were feeling really lucky and super-confident; or maybe that risk questionnaire was completed in 2008 when for sure you thought the financial world was going to collapse. As history showed, it was never as good as it first appeared in 1999 nor was it as bad as it appeared in 2008.

To test yourself how would you have answered these questions in the past, and today?

  • 1987

    Average Allocation

    --
  • 1999

    Average Allocation

    --
  • 2008

    Average Allocation

    --
  • 2014

    Average Allocation

    --
  • 2015

    Average Allocation

    --