Methodology

Questionnaire Philosophy

Simplicity – The average client and advisor should easily understand the questions, answers and results. Our software should be easy to use.

Gets The Job Done – Our questionnaire should help advisors recommend the most suitable investments for their clients.

Research Based – Our questionnaire and approach should be based on academic research, client and advisor experience.

Questionnaire – Section 1 – What Are Your Financial Goals

The first section of the questionnaire reviews a client’s goals. Every professional advisor would agree that financial planning needs goals. It is our belief goals should be SMART – specific, measurable, assignable, realistic and time bound. This is based on George T. Doran’s original management paper “There’s a S.M.A.R.T. way to write management’s goals and objectives.”

We believe SMART goals lead to efficient and effective action. However, these can quickly get complex. We’ve allowed clients to state their goals in a simplistic fashion because they probably won’t know the answers to specific questions (e.g. the amount of income they want in retirement).

Questions

1. Rank your top three financial goals by clicking on the icons below

Possible Answers – Wealth accumulation, Retirement, College Savings, Wealth preservation, Large purchase, More income, Passing on an inheritance, Other (please explain)

Commentary – We begin our questionnaire by reminding clients that the purpose of investing is a life outcome, not a rate of return. Given the wide range of backgrounds of people who complete our questionnaire we err on the side of simplicity. For those who select “Other” we ask them to explain further.

Questionnaire – Section 2 – Your Financial Situation

2. What is the total value of your investment portfolio? Your age? What is your annual income?

Possible Answers – Numbers

Commentary – In order to create a robust financial plan an advisor needs to know a client’s basic financial situation. Although these questions might feel personal, it’s impossible to build a solid plan without these answers.

Questionnaire – Section 3 – How Much Financial Risk Can You Tolerate?

Risk tolerance measures how much risk someone is willing to take. In our questionnaire it includes risk aversion, loss aversion and similar phrases but not risk capacity (that’s in our next section of questions). Risk tolerance is a stable (in the client’s brain) psychological construct. Discussed by Hanna, Waller and Finke in “The Concept of Risk Tolerance in Personal Financial Planning” – 2008 and Roszkowski – “Risk Perception and Risk Tolerance Changes Attributable to the 2008 Economic Crisis: A Subtle but Critical Difference” – 2010. This risk tolerance section of our questionnaire is a psychometric test. Meaning it measures psychological preferences.

The evidence shows that asking clients questions about loss aversion, past and future behavior is a good predictor of portfolio preference and responses to market declines. See Guillemette, Finke, Gilliam – “Risk Tolerance Questions to Best Determine Client Portfolio Allocation Preferences” – 2012. What is key, is having the right questions, in sufficient quantity that elicit a behavioral response. See Grable, Lytton – “Assessing The Concurrent Validity Of The SCF Risk Tolerance Question” – 2012.

We’ve also included elements of Kahneman and Tversky’s – “Prospect Theory: An Analysis of Decision under Risk” – 1979. In our questions we’ve gone to lengths to mitigate anchoring and appreciate that for most people losses feel much worse than gains feel good. See Tversky and Kahneman – “Advances in prospect theory: Cumulative representation of uncertainty” – 1992. Kahneman is now famous for winning the 2002 Nobel Prize in Economics. For those of you who enjoy Kahneman’s work we highly encourage you to watch a discussion with Nassim Taleb on risk.

In this risk tolerance section of our questionnaire we’ve included 10 questions. We’ve been inspired by the aforementioned academics above as well as Rozkowski – “The Survey of Financial Risk Tolerance” – 1994 and Grable, Lytton – “Financial risk tolerance revisited: the development of a risk assessment instrument” – 1999. We’ve also learned from institutions like Vanguard in their paper “Investment risk and financial advice” – 2012.

Most importantly we’ve been listening to financial advisors and their clients for over four years. Building a risk profile questionnaire is a practical exercise, not merely academic. Thousands of individuals have completed Pocket Risk questionnaires and we’ve utilized this experience and data to build a robust product.

3. If you were invested 60% in U.S. stocks and 40% in U.S. bonds during the 2008 financial crisis, your portfolio would have fallen 20.1%. Your [x] investment would have been worth [y]. If a similar event happened again, what might you do with your investments after the fall in value?

Possible Answers – Sell everything, Sell a lot, Sell some, Neither buy nor sell, Buy a lot more, Buy as much as I can

Commentary – This question is designed discover how a client would react in a downturn. Essentially dealing with loss aversion and tackling the problem of the “dual self”. The battle between our rational and emotional decision-making. See Fudenberg and Kline – “A Dual-Self Model of Impulse Control” – 2006.

The first part of the question is designed to mitigate anchoring to today (Tversky and Kahneman – “Judgment Under Uncertainty: Heuristics and Biases” – 1973) by pushing the client to imagine a historical event. The question also uses numbers the client has inputted into the questionnaire earlier on, to make the decision more emotionally significant.

4. If your investments increased 12% (a to b) in year one, then 18% (b to c) in year two, what are you most likely to do in year three?

Possible Answers – Sell everything, Sell a lot, Sell some, Neither buy nor sell, Buy a lot more, Buy as much as I can

Commentary – This question tests how clients feel on the upside. You might be wondering why we give 7 options for many of the questions. This is to ensure variability in responses so we can better pinpoint someone’s risk tolerance score.

5. Have you ever sold investments solely because of a stock market decline?

Possible Answers – Yes, I sold everything, Yes I sold a lot, Yes, I sold some, I neither bought nor sold, No I bought some more, No I bought a lot more, No I bought as much as I could

Commentary – This question was included because advisors have told us they like to ask this question. From their experience it has been a good predictor of future client behavior and an insight into their risk tolerance.

6. The chart below is a representation of U.S. stock and bond market performance from 2005 to 2016 (with dividends and interest reinvested, excluding fees and taxes). Although past performance is no guarantee of future results, which portfolio best suits your desired level of risk and return?

Possible Answers – A, B, C, D, E, F, G

Commentary – A serious challenge for advisors is assisting clients who are financially illiterate. A client’s lack of knowledge and/or terminology to express themselves can result in miscommunication with an advisor. Some clients find it difficult to accept risk because they don’t know the options. See Dow, Da Costa, Werlang – “Uncertainty Aversion, Risk Aversion, and the Optimal Choice of Portfolio” – 1992. This question is designed to help clients know their options (in a simple fashion) and choose what they think is an appropriate portfolio.

7. To what extent do you agree with the following statements? – You have an excellent understanding of financial and investment terms. – You are willing to invest in assets with a limited track record to get higher returns. – You associate the word “risk” with “opportunity”.

Possible Answers – Strongly Disagree, Disagree, Somewhat Disagree, Not Sure, Somewhat Agree, Agree, Strong Agree

Commentary – Question 7 is a series of 3 questions asking clients to agree or disagree to a number of statements about their risk tolerance.

The first question asks clients about their level of financial education. Various papers and dissertations have supported the assertion that more educated people have a higher risk tolerance. See Bucher-Koenen and Ziegelmeyer (2014) and Sahm – “Risk Tolerance and Asset Allocation” – 2007. Thus we test for it the questionnaire.

The second question asks clients about their desire for upside, given the risks of investing in an asset with a limited track record. The third question is looking for a visceral response to the word “risk” as an attempt to assess behavior during a market downturn. Essentially, these questions are asking the client how much risk they are willing to take in different ways to improve the reliability and validity of the final assessment.

8. To what extent do you agree with the following statements? – You are more concerned with maximizing returns than minimizing losses. – You would be comfortable investing in a new business venture. – You are comfortable with financial risk, knowing there can be increases and decreases in the value of your investments.

Possible Answers – Strongly Disagree, Disagree, Somewhat Disagree, Not Sure, Somewhat Agree, Agree, Strong Agree

Commentary – Question 8 is similar to question 7. It is a series of 3 questions asking clients to agree or disagree to a number of statements about their risk tolerance.

Questionnaire – Section 3 – How Much Can You Afford To Risk?

Risk capacity measures how much risk someone can afford to take. This is typically a calculation of existing assets, income, expenses, future earning potential, time horizon and possibly age. Again see Hanna, Chen – “Subjective and objective risk tolerance: Implications for optimal portfolios. Financial Counseling and Planning” – 1997 and Hanna, Waller, Finke in “The Concept of Risk Tolerance in Personal Financial Planning” – 2008. In this section we ask 4 questions. The academic literature on risk capacity is relatively light compared to risk tolerance but experience from clients, advisors, and regulators help to form our questions.

9. How long do you think you will remain invested before taking money out?

Possible Answers – 0 – To 12 or more years

Commentary – This question is included because of academic research (see Hanna, Chen – “Subjective and objective risk tolerance: Implications for optimal portfolios. Financial Counseling and Planning” – 1997) but mostly because of feedback from financial advisors. They want to know if a client plans to sell assets relatively quickly. Using historical analysis it is difficult to predict stock performance in the short-run (less than three years) but if a client plans to invest for decades an advisor can be more confident about future returns. This will alter the investments that are recommended by an advisor and are thus a crucial element in creating a financial plan.

10. How secure are your current sources of income (e.g. job, investment property)?

Possible Answers – Very Insecure, Insecure, Somewhat insecure, Not sure, Somewhat secure, Secure, Very secure

Commentary – Question 10 asks the client to assess the security of their income. Regulators like the UK’s Financial Services Authority (now renamed Financial Conduct Authority) and the Securities and Exchange Board of India define risk capacity as the “ability to absorb falls” in the value of investments that can have a “materially detrimental effect” on a client’s “standard of living”. See Financial Services Authority – “Assessing Suitability” – 2011. It stands to reason income insecurity is a major consideration when assessing a client’s capacity for loss. That is why we have included this question in our questionnaire.

11. How secure do you feel funding an unexpected event like a job loss or a large medical bill?

Possible Answers – Very Insecure, Insecure, Somewhat insecure, Not sure, Somewhat secure, Secure, Very secure

Commentary – Similar to question 10 we are assessing a cleints’s ability to absorb losses.

12. How would you describe your ability to save money?

Possible Answers – Very poor, Poor, Somewhat poor, Not sure, Somewhat good, Good, Very good

Commentary – Again, similar to question 11 this question seeks to discover the client’s ability to absorb losses. A high savings rate (income minus expenses) allows clients to absorb losses and re-invest to meet future financial goals.

Questionnaire – Section 2 Continued – Your Financial Situation

13. Approximately what percentages of your existing investments are in the following assets?

Possible Answers – Stocks – 0%-100%, Bonds – 0%-100%, Cash – 0%-100%, Investment property – 0%-100%, Other – 0%-100%

Commentary – This question is designed to get a window into a clients risk composure and past decisions. If market valuations are low and the client is entirely in cash, it could suggest they are fearful about investing. Alternatively, a person close to retirement might be taking too much risk if they are 100% in stocks.

14. Investors can suffer poor investment performance because of a desire to switch investments on a frequent basis. This can happen when people overreact to good or bad news from the media and friends. How good are you at sticking with your financial plans?

Possible Answers – Very poor, Poor, Somewhat poor, Not sure, Somewhat good, Good, Very good

Commentary – Over time the role of financial advisors has shifted from recommending investments to client behavior control. On average investors lose 1.6% annually because they tend to pull money out of equity mutual funds following a significant decline when equity valuations are most favorable, and conversely increase equity allocations following a recent price increase when valuations are less favorable. See Friesen, Sapp – “Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability” – 2007. Therefore advisors can provide significant value by controlling behavior.

Nick Murray a well-respected financial advisor coach says, “that the dominant determinant of long-term, real-life return is not investment performance but investor behavior. Second, that behavior modification ought to be, in and of itself, an advisor’s value proposition, because great behavioral advice is — at critical moments in an investor’s lifetime — worth so much more than the advisor can ever charge for it.“ – Behavioral Investment Counseling – 2008.

Given the research we have included questions on client behavior. We’ve included two questions to assess risk composure (question 13) and risk perception (question 14)

Risk composure is the possibility that in a perceived crisis the client will behave significantly different to their rational self and take action that could lock-in losses. It can be assessed based on a client’s past decisions.

Risk perception is a judgment by the client that the current economic environment is very risky, even if that judgment is false. The media heavily influences this perception. A lack of financial literacy, education or experience is typically to blame for these judgments.

Question 14 is based on research from Friesen and Sapp mentioned above as well as from Morningstar’s Managed Account Program and Dalbar’s Quantitative Analysis Of Investor Behavior – 2015.

Pocket Risk has a customer who likes to ask his clients how often they watch CNBC and Bloomberg. He says, those who watch such programs are the most difficult to manage because they are constantly reacting to news that doesn’t matter in the long-term.

15. Anything else we should know about your financial situation (optional)?

Possible Answers – Written response, text field

Commentary – Not everything that needs to be known can fit into a multiple-choice questionnaire. This question gives clients a chance to express themselves in sentences.

Conclusion

The Pocket Risk questionnaire is designed to assist financial advisors in knowing their clients, meeting compliance and building winning investment portfolios. We believe we have succeeded with this questionnaire and so do our customers. If you have any feedback or questions please email [email protected].