Risky Profiles

What’s a risk profile?

South face of Annapurna I. Photo: Gianni Scopinaro. Source: Flikr

A risk profile is one of those questionnaires you fill out when you open an investment account. To many people, the task seems silly. We just want our money to work for us. And we often have multiple goals: saving for retirement, preserving a nest-egg, maybe a down payment on a house. The questions seem to push us into a box.

Like many apparently pointless things in our lives, these forms – either online or paper – are there to satisfy a regulation. In this case, Rule 2111 of the Financial Industry Regulatory Authority (FINRA), which requires that investment firms gather information on a customer’s “risk tolerance.”

But they don’t specify what they mean by risk. So some firms have a one-line form: state your risk tolerance – low, medium, or high. Not very helpful. Others have a 50-question maze, collecting data on our income, savings, favorite sports, and whether we put cream and sugar in your coffee (I made that last one up). But the forms aren’t always followed. In one study, questionnaires were filled out in the most conservative way possible by a set of researchers. The firms then came up with an equity allocation that ranged from 0% to 70%. Another academic analyzed more than 180,000 brokerage accounts and found that risk tolerance explained about 13% of the share of risky assets in the portfolios.

Risk isn’t a one-line item, or even a five-region zone, like the elements of taste on the tongue. It’s an ever-evolving matrix of our preferences and aversions, and it’s highly sensitive to our context. Suppose you had $100 investment and it lost $10, would you buy more or sell? Only a few would sell. But if we start with $10 million and lost $1 million, a lot more of us would sell – that’s real money! But we know that the question is identical, in percentage terms.

Source: CFA Institute

The regulation isn’t pointless. Some people want to be more conservative with their money, and for good reason. They may have had a bad experience, or they may have just retired and aren’t earning a paycheck anymore. Our tolerances and preferences are real, and need to be respected. It’s just that our tools for assessing it are primitive.

Instead of just filling out a form to satisfy a compliance officer, advisers need to understand that helping clients understand their personal attitude towards risk and uncertainty is one of the most important parts of their job. Our family history, a history of our financial transactions – especially what we did during the financial crisis and the bull market afterwards – and our life circumstances all help paint a more complete picture.

Photo: Dave Meier. Source: Picography

No one really likes generic questionnaires. They seem heartless, and they often appear pointless. Instead, we need to have ongoing conversations about risk – our history, our aspirations, our goals, and our concerns. Only then can we craft portfolios that meet our goals – all of our goals.

Douglas R. Tengdin, CFA

By |2017-07-17T12:21:26-04:00April 4th, 2017|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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