It is a staple of financial advising to measure a client’s risk tolerance; whether out of a mere regulatory requirement to do so, or out of a best practices desire to better understand a client’s comfort level with the investments (and other financial planning advice) being recommended, so process to measure risk tolerance is essential in today’s world.
Yet many financial advisors severely question the value of doing so; as the saying goes, “Clients are risk tolerant in bull markets, and intolerant of risk in bear markets, so is there really that much value to going through the exercise at all?” And a recent academic presentation at the FPA Experience conference added fuel to the fire, showing a remarkably high correlation between the monthly average risk tolerance scores of a well respected measurement tool, and the monthly level of the S&P 500.
Yet a deeper look reveals that while even the best risk tolerance measuring process is not totally immune to the vicissitudes of the market, a client’s true risk tolerance appears to be remarkably stable and doesn’t change much at all in the midst of volatile markets. Instead, what appears to be unstable is not the client’s tolerance for risk, but their perceptions of risk in the first place; in other words, clients may be loading up on stocks in bull markets not because they’re more tolerant of risk, but because they don’t think there is any risk in the first place. In turn, this suggests that ultimately, it may be time for financial planners to more widely adopt quality tools to measure risk tolerance, but simultaneously recognize that managing client (mis-)perceptions of risk is the real challenge that we face.