Why the right risk-tolerance tool ensures consistent defensible advice

This article was produced in partnership with Morningstar

“Risk tolerance is a personal trait, much like a personality trait, enduring over a lifetime,” explains Nicki Potts. The director of financial profiling and planning at Morningstar clarifies the often-confused terms of risk tolerance and risk profile. Potts highlights the significance of validity and reliability in risk assessment tools, and how Morningstar ensures the effectiveness of its tools through rigorous processes.

Risk tolerance can be measured using psychometrics, a field combining psychology and statistics to ensure the accuracy and reliability of assessment tools. On the other hand, a risk profile encompasses risk tolerance and various other factors like needs, capacity, experience, and knowledge. Therefore, an individual might have a singular risk tolerance but multiple risk profiles tailored to different financial goals such as retirement or education.

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.

So why do many advisors believe clients become more risk-averse during downturns, and why do clients often panic sell during market crashes if risk tolerance is stable? It’s likely not the risk tolerance that changes but rather the perception of risk in the marketplace. Clients might be comfortable with a 30 percent drop in their portfolio value, but fear induced by media warnings of severe economic crises can trigger irrational decisions.

Potts emphasizes the need for clear communication, assuring clients, “This is what you're comfortable with, this is the profile we've set for you, and these are the range of possible outcomes you can expect. Here's the deepest drawdown, and here’s how long it could take to recover. This is what you can expect in the long term.'

“With this understanding, clients can block out market noise and focus on their long-term goals. It’s about aligning their portfolio with their profile, reviewing the progress they've made so far, and maintaining perspective. The past is behind us, the present is happening now, but let's focus on the progress toward your goals. It's about recognizing the hard work and the journey you've undertaken.”

If advisors have set expectations correctly, they can use volatile times—or even periods when markets are doing well—to remind clients not to get overly excited. Behavioral coaching and guidance can work to a degree, but even seasoned investors can get carried away when mania sets in.

Using the tools to establish guardrails

During periods of manic panic, there's a fear of missing out. People think, ‘Everyone’s doing it, so I should be too.’ We can't stop human emotions—humans are emotional and sometimes irrational. The best advisors can do is put guardrails in place.

Advisors need to constantly re-coach and realign clients, suggesting practices like not checking portfolios every day but instead once a month or quarterly. If someone is prone to impulsive decisions, they could invest in less liquid assets, making it harder to trade on whims.

These simple strategies help prevent impulsive actions. When clients do feel the urge to act, they'll remember the reasons behind these guardrails.

It's crucial for advisors to manage risk assessment and client profiles holistically, aligning them with progress toward their goals. Advisors must help clients maintain perspective amidst market fluctuations, keeping them focused on their long-term objectives.

Potts underscores the importance of personalization in financial planning and the irreplaceable role of human advisors. “Advice has got nothing to fear,” Potts maintains, “Those who truly understand the real meaning and process of planning know it's not just a robo-system where an AI can spit out a score and assign a portfolio.

“Advisors are essential for coaching, guiding, and empowering clients to make decisions. That's the true value of an advisor, which AI can't replicate. Any tool used should offer personalization to help build strong client relationships and a point of difference. With this approach, there's nothing to worry about.”

Morningstar’s commitment to maintaining the reliability and comprehensiveness of their risk profiling tools is evident in their data-driven approach. “We have a global database and continuously review our tools based on feedback from advisors. Our process is science-based, ensuring that our tools remain effective and reliable,” Potts assures.