EDITED BY:

Joachim Klement, CFA

If risk aversion and willingness to take on risk are driven by emotions and we as humans are bad at correctly identifying the emotions, then the finance profession has a serious challenge at hand: how to identify reliably the individual risk profile of a retail investor or high-net-worth individual. In this series of CFA Institute Research Foundation briefs, we have asked academics and practitioners to summarize the current state of knowledge about risk profiling in different key areas.

This series, which began in 2015 and continued through 2018, launched with “Investor Risk Profiling: An Overview.” In this brief, author Joachim Klement, CFA, determines that the current standard process of risk profiling through questionnaires is highly unreliable and typically explains less than 15% of the variation in risky assets between investors—mostly because the questionnaires focus on socioeconomic variables and hypothetical scenarios. However, the existing research in risk profiling shows that several factors can provide more accurate and reliable insights into the risk profile of investors. Among these factors are the investor’s lifetime experiences and past financial decisions as well as the influence of family, friends, and advisers. By using these factors, practitioners can better understand their clients’ preferences and recommend suitable investment strategies and products.

In “Risk Profiling through a Behavioral Finance Lens,” published in 2016, author Michael Pompian, CFA, examines risk profiling through a behavioral finance lens. Behavioral finance attempts to understand and explain actual investor behavior, in contrast to theorizing about investor behavior. It differs from traditional (or standard) finance, which is based on assumptions of how investors and markets should behave. Much has been written about the tension that exists between the willingness to take risks and the ability to take risks—risk appetite is the former and risk capacity is the latter. In the behavioral context, risk appetite and risk capacity are defined in terms of known risks and unknown risks. Irrational client behavior often occurs when a client experiences unknown risks. To aid in the advisory process, advisors can use behavioral-investor types to help make rapid yet insightful assessments of what type of investor they are dealing with before recommending an investment plan. With a better understanding of behavioral finance vis-à-vis risk taking, practitioners can enhance their understanding of client preferences and better inform their recommendations of investment strategies and products.

From 2017, in “Financial Risk Tolerance: A Psychometric Review,” author John E. Grable provides financial analysts, investment professionals, and financial planners with a review of how financial risk-tolerance tests can and should be evaluated. He begins by clarifying terms related to risk taking and then provides a broad overview of two important measurement terms: validity and reliability. He concludes with examples for practice.

In “Risk Tolerance and Circumstances,” published in 2018, authors Elke U. Weber and Joachim Klement, CFA, determine that an investor’s risk attitude is a stable characteristic, like a personality trait, but that risk-taking behavior can change based on the investor’s age, recent market events, and life experiences. These factors change investors’ perceptions of risks. Differences in risk tolerance between men and women or in different circumstances trace back to emotional as much as rational considerations. Financial advisers should consider all of these factors when advising clients and can use four simple steps to incorporate best practices: be aware, educate, nudge, and hand hold.

Finally, in the 2017 publication “New Vistas in Risk Profiling,” author Greg B. Davies explains that risk profiling is fraught with misunderstandings that lead to ill-advised approaches to determining suitable investment solutions for individuals. The author discusses how we should think about the crucial elements of (a) risk tolerance, (b) behavioral risk attitudes, and (c) risk capacity. He uses a simple thought experiment to examine a stripped-down investor situation and define the essential features and exact role of each of the components of an investor's overall risk profile. Davies concludes by examining options for eliciting and measuring risk tolerance and considering some promising avenues for future methods.