Assessing risk tools
Just as a person doesn’t shift from being an introvert to an extrovert overnight, their risk tolerance remains stable over time and market conditions. Not all questionnaires claiming to measure risk tolerance are created equal. A robust test should be both valid (measuring what it claims to measure) and reliable (providing consistent results over time). Potts states, “If you say it’s a risk tolerance tool, it should measure risk tolerance and nothing else. Reliability means it should produce similar results when used repeatedly under the same conditions.”
Discussing Morningstar’s approach, Potts highlights the rigorous process behind their risk profiler, originally developed by FinaMetrica. “Our tool has been measuring risk tolerance for over 20 years, setting the standard globally,” she says. The tool’s effectiveness is rooted in its extensive development and continuous improvement, backed by a global database of nearly 2 million profiles.
Data from the Morningstar Profiler, spanning various market conditions, demonstrates remarkable consistency in average scores. This consistency is crucial. If a client’s risk tolerance fluctuated every time they met with an advisor, providing consistent, defensible advice would be challenging.
The value of conversations in risk assessment
One of the critical insights Potts shares is the real value derived from the conversation between advisors and clients, facilitated by risk assessment tools. “The value is not in the score but in the report and the ensuing discussions. These conversations help clients make better financial decisions,” she notes. The dialogue initiated by these tools allows advisors to set correct expectations and guide clients through volatile market conditions.
Dangers of short-term volatility on risk assessment
A risk tolerance test influenced by short-term market volatility poses dangers for both clients and advisors. For instance, if a poorly constructed test during a bull market suggests clients are more aggressive than they truly are, they might panic sell during a downturn, realizing losses. Conversely, a faulty test during a bear market might indicate excessive risk aversion, leading to overly conservative investments and unnecessary sacrifice of returns. Such inconsistencies make it difficult for financial planners to demonstrate to regulators that their tools are fit for purpose.
