By Peter Mastrantuono
Last week we discussed what advisors assess to determine an investor’s risk tolerance, touching on three critical elements: willingness to take risk, the capacity to take risk and perceived situational risk.
In this week’s article we’ll examine some of the more innovative approaches to helping financial advisors gain a more complete understanding of their client’s risk profile.
You’ve Come A Long Way
Early attempts to gauge an investor’s risk tolerance were, by today’s standards, quite primitive. It wasn’t unheard of that a questionnaire might ask an investor his or her recreational pursuits to measure risk propensity, as if being a downhill skier provided any insight into an investment personality.
The questionnaires used today reflect decades of advancing the art and science of determining an individual’s risk profile. Ask any thoughtful observer, however, and he or she will admit there remains room for improvement.
There are several risk assessment products that seem to be moving the process toward a higher level of precision. Among the leaders are FinaMetrica, Riskalyze, Tolerisk, and a more recent entrant, Andes Wealth.
Different Strokes for Different Folks
These new pioneers are pursuing two very different approaches to risk assessment.
One way to determine an investor’s risk profile is through a psychometric method that uses statistical techniques to see through the biases and inaccuracies of the answers individuals provide on the questionnaire. The aim is to ensure that it accurately measures what it wishes to measure.
This approach incorporates a range of inputs (e.g., tolerance for losses, reaction to gains, allocation preferences and financial knowledge). Since the accuracy of this approach increases with the number of questions asked, these questionnaires tend to run longer than more conventional ones.
The other approach is an econometric assessment that relies more on classical economic and behavioral theories, using questions to capture an individual’s position on the utility curve.
The psychometric approach is designed to be the start of a conversation about risk and asset allocation between the advisor and his or her client, while the econometric method is designed to provide “the answer.” (The major risk tolerance software apps that use psychometric method are FinaMetrica and Tolerisk, while the econometric approach is used by Riskalyze
As we mentioned in last week’s article, an investor’s risk profile is not only defined by his or her willingness to assume risk, but also by his or her capacity to assume risk, which two of the programs incorporate—FinaMetrica and Tolerisk.
Andes Wealth is a unique offering in that the path toward determining risk tolerance involves an interactive exercise between client and advisor and adds an overlay of investor behavior (trend follower, safety seeker, the passive investor, contrarian, risk seekers and adaptive investors). Together they map the client’s risk profile score to an actual point on the efficient frontier.
While these programs represent real progress in assessing investors’ risk profiles, the traditional role of an advisor in interpreting a client’s spoken and unspoken preferences and concerns remains as essential as ever.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.