Don’t tolerate mistakes on measuring risk tolerance

Dr Greg B Davies, Head of Behavioural Finance, Oxford Risk writes that the right level of risk for an investor to take depends, to some extent, on that investor’s balance sheet. The more an investor relies on investments to fund their life, the lower their capacity to take risk with that portfolio. 
 

Imagine that due to an oversight, our investor received the wrong advice because the balance sheet was missing a crucial piece of information. If this were an adviser’s error, it would be malpractice. We’re talking about the risk level to apply to the savings of the life lived so far, with a view to funding all the goals of the life still to live. It’s important to record this information accurately. 
 
So far, so uncontroversial, hopefully. But what about the other major determinant of the right level of risk to take – an investor’s risk tolerance? 
 
Pay attention how risk tolerance is measured 
 
The need for accuracy with risk tolerance is just as obvious – mistakes in measuring risk tolerance affect those same life savings and life goals. But measurement errors – despite being common – aren’t nearly as obvious and are all the more dangerous for it.  
 
Too often the measurement of risk tolerance is paid minimal attention. Approaches may have moved beyond mere subjective box-ticking, but often they get stuck believing all questionnaires are equally valid. 
 
A question we’re often asked by advisers is: 'How do I take into account my client’s risk tolerance changing?’  The short answer is that this is very rarely the case; and where it looks like it is, it’s usually a red flag for a faulty measurement methodology, the creation of unnecessary work for the adviser, and a poor investment outcome for the client.  
 
Risk tolerance, measured correctly, is a stable, long-term psychological trait. Stability is a hallmark of psychometric traits – as opposed to states, or fleeting feelings, which may change every time someone’s circumstances do.  

Measuring risk tolerance correctly 
 
A robust and reliable measure of risk tolerance should therefore never display the sort of instability that some purported measures of it do. Risk tolerance can change, but it’s rare. An unstable measurement is far more likely to reflect the inadequacy of a test than the changing psychology of an investor. 
 
Many tests claim to be asking: ‘How much risk are you willing to trade-off for better returns in the long-term?’ but end up asking: ‘How do I feel about taking investment risk this morning?’ This isn’t even measuring the right thing badly; it’s measuring the precisely wrong thing.  
 
Any measure of risk tolerance that displays such instability and sensitivity to the immediate context should absolutely never be used to guide the construction of long-term portfolios. Moreover, such unstable measures are inherently procyclical: they register high levels of ‘tolerance’ when times are good, and lower when times are bad. Building ‘buy high, sell low’ into an investment process is self-evidently a bad idea. 
 
Very few tests get this right. Sadly, having any risk tolerance test is more strongly and immediately incentivised than having an accurate one. And while the size of the stakes is indisputable, the feedback loop on mistakes is so loose as to be unusable.  
 
How not to measure risk tolerance 
 
Fortunately, while knowing if a test is confusing or confounding a measure of risk tolerance with other attitudes, behaviours, or personality dimensions can be difficult without rigorous scientific testing, there are other clear ways to tell if your risk tolerance measurement is not fit for purpose though you have to know how to look for them.  
 
Tests that require numerical calculations, probabilistic reasoning, or investment knowledge should be avoided. If it references current market conditions, then it is not fit for purpose, and if it uses past behaviours – revealed preferences – as a guide then it is not measuring risk tolerance correctly.