Beyond the Questionnaire: New Tools for Risk Profiling


Joachim Klement, CFA

The current practice of identifying investor risk profiles is inadequate and unreliable, according to Joachim Klement, CFA, chief investment officer at Wellershoff & Partners. The processes currently used typically explain less than 15% of the variation in risky assets between investors. Klement’s research suggests that analyzing a client’s environment, their lifetime experiences, and their genetic disposition for risk taking can lead to more reliable assessments of investor risk profiles and, consequently, better risk identification.

Determining Attitudes toward Risk

There are two aspects to a person’s risk profile. First is a person’s capacity to take on financial risk, which is a function of one’s economic circumstances and such things as income, wealth, and investment horizon — none of which are dependent on emotion or behavioral biases. The other aspect of a person’s risk profile is his or her emotional ability to take risks, which is based on an investor’s attitude toward financial risk and the degree of psychological or emotional pain experienced when facing or contemplating financial loss.

This combination of risk capacity and risk aversion forms a person’s risk profile. Determining these traits can be problematic, however, because there are no generally accepted measures of financial capacity or a list of psychological traits that determines risk aversion.

Because risk capacity and aversion are unique for each person, the combination or risk profile is also exclusive to every individual. For an individual investor, the only suitable investments should be those that fit within the intersection of a person’s risk capacity and risk aversion. This is an important distinction because the biggest complaint from investors is that the products purchased or recommended by advisers were not suitable to meet their financial goals.

Questioning Traditional Approaches

Basing investment policy on traditional assessment tools, customarily performed through a survey or questionnaire, can be a significant issue for professionals and investors alike. Although the exact methods are not prescribed, determining a client risk tolerance in advance of making investment recommendations is often required by regulators, for example by FINRA (Financial Industry Regulatory Authority) in the United States and by MiFID (Markets in Financial Instruments Directive) II in Europe.

The current tools are unreliable because many lack basic questions about investment behavior, time horizon, investment goals, and investment experience, while even fewer ask about withdrawal rates or liquidity needs. 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 as a part of the profiling process, admits that the answers from questionnaires “are often unreliable because many clients are inexperienced or misinformed.”

Klement took this concern one step further when he suggested another potential problem with client answers: specifically, that customers may have attitudes and biases that contradict what they believe about their own emotional and financial ability to take risk.

Because the traditional method of questioning clients has not been successful at explaining the variation in risky assets, what can be done to better determine an investor’s risk profile? According to research done by Klement and Robin Miranda, there are three factors that have the greatest impact on a person’s attitude toward risk and the development of an applicable and useful investment policy:

  1. One’s hereditary penchant to take on financial risks
  2. One’s friends and acquaintances and their influence on framing opinions
  3. One’s life experiences, especially in the formative years

A Need for New Assessment Tools

New approaches to determining clients’ attitudes toward investing require new methods and tools for understanding a person’s experience and natural comfort with risk. Because of the lack of specific guidance around risk profiling, Klement suggests that regulators provide investment professionals with direction regarding the use of new assessment tools. In the interim, he provides some practical tools that can aid investment professionals in determining a client’s penchant for risk:

  1. Financial anamnesis: Just as doctors interview family members to discover a patient’s genetic potential for disease, advisers can determine a client’s risk preferences by ascertaining the financial habits of relatives. A person’s attitude toward money and investing is shown to be highly correlated to the feelings of their parents and other family members.
  2. Investment diaries: The best method to investigate a person’s past investment history is through an investment diary in which an investor records transactions as well as the reasons for those transactions as they make them. Over time, the journal forms an image of the individual’s investment preferences and constraints and provides a foundation for developing a substantiated risk profile.
  3. Investment history: Advisers can gather information for the development of risk profiles by taking a client’s investment history and relating past actions to the current market. For example, someone who spent his formative years as an investor in a bull market might have a very different opinion about equity investing than one who did the same during a recession. The financial history can point to where an investor might be overly risk averse or conversely unaware of investment threats.

Although we may believe that our investment preferences and constraints are developed rationally and are shielded by psychological or emotional influences, the reality is that a considerable portion of our views and opinions may be predetermined and then molded by our experiences. It is by delving deeper to understand these influences that advisers can paint a more representative and useful picture of their clients’ investment penchants and proclivities.

If you liked this post, consider subscribing to the CFA Institute Annual Conference blog.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: W. Scott Mitchell

This entry was posted in News and tagged , . Bookmark the permalink.

Leave a Reply

Your email address will not be published. Required fields are marked *