An investor’s risk tolerance varies dramatically according to one’s personality and experiences. Experts say the best way to determine your risk tolerance is to objectively measure it. Financial advisers often test individuals to determine their risk tolerance before deciding on which investments to make.

According to Riskalyze, a firm that produces a tool to measure risk tolerance, there are two key reasons why risk preferences must be the starting point for a discussion between financial advisers and their clients.

The first way an adviser adds value is to act as the caretaker for the investor’s portfolio; the second is to improve on the investor’s decisions. In both cases, this must involve an accurate and actionable understanding of the client’s risk preferences.

"By adding knowledge and subtracting emotion, advisers can improve investors’ portfolio choices. More subtly, an investor may not be able to implement her own risk preferences when choosing a portfolio," says Riskalyze in its white paper, Application of Preference Measurement: The Case of Riskalyze.

According to risk tolerance experts FinaMetrica, your risk tolerance is generally stable over time and tends not to fluctuate with changing markets. FinaMetrica co-founder Paul Resnik says risk tolerance is best understood as a personality trait.

"Age and education tend not to change it. Experience, such as personal financial pain, however, may do so. Individuals are exactly that, individual, so it’s best re-assessed every two or three years," says Resnik.

FinaMetrica uses psychometrics, a blend of psychology and statistics, to determine and quantify risk tolerance. “Risk tolerance is most accurately assessed by tests using methods specifically designed to determine personality traits. Psychometrics is the science that provides the most valid and reliable results,” says Resnik.

Countplus one financial adviser Jan Adamson uses an eight-question risk profiler provided by the Count dealer group. She also talks to clients about their investment experience.

"I use the risk profiler questionnaire as a basis for risk tolerance discussion because it is important to understand what is behind the responses. I generally ask about the investor’s experience and reactions during the GFC. This provides a great reference point as most clients at least had superannuation investments during that time. This leads to a discussion of market volatility and what that means," says Adamson.

"We use a graphic showing risk/return for various risk profiles over a 30-year period, which helps to explain the trade-off between capital preservation and longer-term performance," she says.

According to robo adviser Schwab Intelligent Investor, investors’ willingness to accept risk is typically indicated by the level of volatility they are comfortable with.

"Details about investors’ risk willingness can be obtained by asking questions related to behavioural tendencies, such as the action they may take after experiencing a significant investment loss or have taken in the past when faced with a significant investment loss," says Schwab in their white paper Investor Profile Questionnaire White Paper.

As part of a paperless, online enrolment process, Schwab Intelligent Portfolios™ includes an Investor Profile Questionnaire, which asks clients a series of short questions to determine whether a more conservative or more aggressive portfolio is suitable.

FinaMetrica’s Resnik says understanding an investor’s risk tolerance is key is to avoiding emotional decision-making when the market moves.

“For instance, an investor with a low risk tolerance and a high exposure to shares and property in their portfolio may find it difficult to remain fully invested when there is a drop in the value if their investments. Their inclination may be to sell down all or part of their portfolio to diminish their anxieties. Should they do so it raises another question: when and how do they buy back into the market? 

“Market timing is the scourge of good outcomes. Analysis of portfolio returns over time show, all else being equal, that those who buy and sell more regularly tend to underperform those that trade less often. Not only do the transactions incur costs they sometimes trigger taxes – both need to be compensated for in future returns. The data shows that reasonably diversified portfolios with quality assets usually recovers losses in the medium term,” says Resnik.

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Nicki Bourlioufas is a contributor for Morningstar Australia. 

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