Assessing an investor's risk tolerance is a standard required by several governing bodies worldwide. This is a precautionary measure which helps to ensure investors are offered suitable options according to their risk tolerance, or appetite for risk. This service is occasionally offered by firms in regions whose regulators do not mandate risk tolerance assessment.
Whilst this is good practice, an underlying issue remains: many platforms do not assess an investor's risk tolerance in a defensible manner.
The most popular form of establishing an investor's tolerance for risk is a psychometric questionnaire. It is essential that the questions are academically analyzed together; inaccurate questions lead to inaccurate results. This is generally applied but there are still many platforms , which, in our opinion, use sub-standard questions and methodologies.
Gaining a clear understanding of an investor's risk profile goes beyond establishing their tolerance to risk. There must also be an understanding of suitability. An investor may have a high tolerance to fluctuations in stock values and it could be assumed that they would be placed into a high-risk tolerance category. However, this needs to be scaled according to their tolerance for risk relative to other investors of their demographic. Also, there needs to be an understanding of the investment goal, time horizon, and capacity for loss.
If an investor is placed in an appropriate risk tolerance category, there is still no way of understanding which investment are suitable for them until their time horizon is considered. Various options will mature over varying time periods, so this must be considered if the investor's goals are likely to be achieved. An example would be someone who is saving for their child's college fund. They have a clearly specified time horizon and goal for their investment. Alternatively, someone investing in their 30's for their retirement has a much longer time horizon and ability to ride out major fluctuations in the stock market. Accordingly, these two investors should be offered different investment options.
Therein lies the difference of appropriate risk tolerance profiling and one that can fall short of offering results that investors can have confidence in.