As investors, we all navigate the financial landscape with a unique compass: our risk tolerance. Understanding how much risk we’re comfortable taking is fundamental to building a portfolio that aligns with our goals and keeps us psychologically sound, especially when markets get choppy. For years, the go-to tool for measuring this crucial element has been the self-reported questionnaire. We’ve all likely encountered them – a series of questions designed to gauge our feelings and attitudes towards potential financial gains and losses.
And why not? On the surface, questionnaires seem like a straightforward way to tap into an individual’s mindset. They allow us to collect valuable insights into what people think and believe about risk, and how they see themselves when facing financial uncertainty. This information can indeed provide a glimpse into their preferences and feelings.
However, just like any tool, risk tolerance questionnaires have their limitations. Relying solely on them can paint an incomplete – and sometimes misleading – picture of your true risk appetite. Let us look at some of the main shortcomings:
1. The Trap of Self-Reflection
When individuals encounter hypothetical risk-related questions in a questionnaire, such as “Which of the five potential portfolios, ranging from conservative to aggressive, would you feel most comfortable with?”, they tend to engage in deliberate and conscious thought. This can lead to overly rationalised answers that don’t necessarily reflect their true emotional response to real financial losses.
For instance, when considering different portfolio options, a respondent might reasonably think that to achieve their long-term financial goals, they should be comfortable with some level of market fluctuation. This logical reasoning might lead them to select a riskier option on paper. However, when their portfolio actually experiences a significant downturn, their emotional discomfort of real losses might be much greater than their initial, rationalised response indicated.
2. Hypothetical Scenarios
Risk tolerance questionnaires often present hypothetical scenarios that individuals may have never experienced firsthand. Consider a statement like, “I am comfortable with investments that may frequently experience moderate decline in value”. A novice investor who has only experienced a bull market might intellectually agree with this statement, believing they can handle such volatility. However, when faced with their first substantial market correction and observing a significant decrease in their portfolio value, their actual emotional and behavioural response could be far more risk-averse than their initial, theoretical answer suggested. They simply lack the experiential context to accurately assess their true comfort level in such a real-world scenario.
3. The Disconnect Between Intentions and Actions
What we say and what we do when faced with potential losses can be vastly different. Risk tolerance questionnaires capture our stated intentions and beliefs about risk when we are in a relatively calm, analytical state of mind. In “cold mind” situations, we can carefully consider the potential outcomes and choose responses that align with our perceived long-term goals. However, under genuine financial pressure our behaviour can differ substantially from these reasoned responses. An unexpected and significant market downturn can trigger fear, anxiety, and stress which eventually override our previously stated risk comfort level.
4. The Influence of Fleeting Feelings
The influence of fleeting feelings significantly undermines the reliability of risk tolerance questionnaires because our emotions play a substantial role in both our decision-making and risk behaviour. Positive feelings, such as optimism and happiness, can lead investors to exhibit higher risk tolerance than usual, potentially leading them to select riskier investment options in a questionnaire. Conversely, negative emotions like fear, pessimism, or sadness tend to make individuals more risk-averse, potentially causing them to indicate a lower risk tolerance in their responses. The critical issue with questionnaires is that they provide a snapshot of an individual’s self-assessed risk tolerance at a specific point in time. That can be strongly influenced by the prevailing mood and skew the assessment of risk towards greater or lesser risk acceptance.
5. The Complexity of Risk Tolerance
The complexity of risk tolerance further highlights the limitations of relying solely on questionnaires, as empirical research firmly establishes that it is not a simple, unidimensional trait. Instead, risk tolerance is a multidimensional construct influenced by a wide array of interconnected factors. These factors include biological elements like genetics and hormone levels; demographic aspects such as age, gender, education; financial knowledge, investment experience, and wealth; affective factors encompassing feelings and emotions; cognitive abilities such as literacy and financial skills; individual differences like risk perception; and psychological inclinations such as loss aversion and time preferences. A questionnaire, with its typically limited set of questions, struggles to comprehensively capture this multifaceted nature of risk tolerance.
6. The Illusion of a Uniform Risk Score
We often assume that a risk tolerance questionnaire can neatly categorise individuals into distinct risk profiles. However, the reality is far more nuanced due to the inherently subjective nature of risk tolerance. Questionnaires rely on our individual interpretation of risk, which can be influenced by our beliefs, knowledge, emotions, and past experiences. In addition, questionnaires typically employ cumulative scoring systems – where responses to individual questions are aggregated to produce an overall risk tolerance score. These two factors – the complexity of risk and the cumulative scoring – might create a misleading sense of uniformity in assessment outcomes.
Consider that two individuals might both score a “moderate” risk tolerance on a questionnaire through cumulative calculation. However, the path they took to arrive at that identical score could be dramatically different. The first individual might perceive discomfort with high volatile investments but be comfortable with illiquidity, while the second might feel comfortable with high volatile investments but uncomfortable with illiquidity. The cumulative score, while seemingly providing a clear categorisation, also highlights how a single, aggregated score might fail to capture the nuances in risk preferences and conceals the real drivers of risk behaviour.
While risk tolerance questionnaires offer a valuable initial insight into an investor’s stated attitude towards risk, it is crucial to acknowledge their inherent limitations. Therefore, to gain a more comprehensive understanding of an investor’s true risk tolerance, a more holistic approach is essential. This should ideally incorporate behavioural assessments that simulate gamified real-world investment scenarios and simulations, allowing for the observation of actual responses to financial challenges, rather than relying solely on stated preferences.