Risk Tolerance Philosophy
Risk Tolerance & Suitability
The financial services industry is held to suitability requirements by both the SEC and FINRA (which defines risk tolerance as “a customer’s willingness to risk losing some or all of the original investment in exchange for greater potential returns”). FINRA rules state that a client’s risk tolerance must be considered when determining the suitability of an investment.¹
What FINRA and the SEC do not define are clear guidelines for determining an investor’s risk tolerance. As a result, advisors use a range of methods for determining risk tolerance, often with questionable accuracy. For example, many “risk tolerance” surveys ask questions related to the investor’s ability (or capacity) to take risk, and then use the answers incorrectly to determine willingness to take risk.²
Issues with measuring risk tolerance exist outside the US as well. In fact, regulators in major EU markets have found that up to 90% of assessments of clients’ risk tolerance were invalid and unreliable, which let to unsuitable investment advice.³ Fortunately, regulators in the UK have provided guidelines for measuring risk tolerance. And, even though US advisors are not required to follow the UK standards, we believe it is in the best interest of all advisors and investors to follow defined standards in assessing risk tolerance.
That’s why our Behavioral Risk Survey adheres to the following best practices outlined by the UK’s Financial Services Authority:
- Questions should be clearly worded and easily understood using simple language.
- Surveys should be long enough so that a single inaccurate answer will not result in a customer being allocated to a higher-risk category.
- Questions should avoid having a non-committal “middle answer.”
- Surveys should separately measure willingness and ability to take risk, and not combine the two into a single output.4
Here’s a brief example of why both ability and willingness to take risk are important, yet separate:
A 25-year-old client could technically have a high ability to take risk, but not all 25-year-olds are comfortable with volatile portfolios. Therefore, if you put your client into too many high-risk investments based solely on ability, without realizing the client happens to have a very low willingness to take risk, the decision could result in a very unhappy client.
At the end of the day, if a client is so uncomfortable in an investment that they end up “selling low” during a market correction, a high-risk portfolio is probably not a good fit.
Our approach to assessing risk tolerance is proprietary and unique because, as you may have noticed, traditional risk surveys tend to focus solely on ability to take risk, or factors such as age, income, and wealth. On the other hand, behavioral finance focuses primarily on willingness to take risk, examining:
- Motivations for behavior
- Attitudes toward investing
- Comfort levels with loss and volatility
Finworx operates on key principles of behavioral finance, relaxing the “rational” assumption held in traditional finance and economics to account for how human beings actually make decisions—rather than how we should make decisions. Consistent with research from Michael Pompian and Richard Thaler and our extensive exploration of behavioral investor types, we designed our Behavioral Risk Survey to help assess your clients based on two factors:
- Willingness to take risk (from conservative to aggressive)
- Propensity toward emotional vs. cognitive biases
Essentially, our risk assessment is specifically designed to provide a more holistic picture of each client’s true risk tolerance.
Once you have a high-level view of the client’s risk tolerance, you can better personalize their investment strategy, communicate effectively, and avoid potential disappointments. Education is a key component of setting your clients’ expectations and helping them meet their goals, and we believe your understanding of the fears, concerns, and potential biases of your clients will help improve outcomes for them and you.