Risk Tolerance Questions to Best Determine Client Portfolio Allocation Preferences

Abstract

The literature on risk tolerance overwhelmingly justifies the use of questionnaires based on validity and reliability or psychometric testing, but there has been little research examining the relation between questions and actual investor portfolio behavior. This study examines risk tolerance questions based on economic theory, prospect theory, and client self-assessment to determine the extent to which they explain variation in portfolio allocation preference and recent investment changes. We conclude that risk tolerance questions based on loss aversion and self-assessment should be used when determining the portfolio allocation of clients. While questions based on economic theory should theoretically be the best measure of a client’s portfolio allocation preference, the results of this study indicate that these questions are not very useful when both loss aversion and self-assessment questions are included in a risk tolerance questionnaire. Financial planners should begin to reassess the risk tolerance level of their clients around age 60, as there is evidence that risk tolerance declines later in life because of cognitive decline.

Keywords: risk tolerance, portfolio allocation, portfolio choice

JEL Classification: G11, D81, E62