Sunday, October 20, 2013

Can we measure risk tolerance?

One of the many interesting presentations here in Orlando at the Financial Planning Association's annual FPA Experience conference was "Changing Risk Tolerance" by Michael Guillemette of the University of Missouri and Michael Finke of Texas Tech University. 

An important question we all face is, can we measure risk tolerance? Joe Tomlinson's column in this week's Advisor Perspectives provides more background on this issue. 

In trying to measure risk tolerance, what we really want to know is: what is the most aggressive asset allocation someone can withstand before they will otherwise sell their position and leave the market after a drop, or will feel unable to sleep peacefully at night.

There is an active research literature on this topic, which I must admit I am not fully up to speed with the arguments and conclusions. One of the debates is about whether people have a constant underlying risk tolerance which is part of their individual personality, or instead that risk tolerance is fungible and may depend more on perceptions about what is currently happening in the market.

Michael Guillemette presented his research using the average risk tolerance as measured on a monthly basis for individuals with data collected from a well-respected company that focuses on measuring risk tolerance. He presented a figure which I thought was fascinating:

What this figure plots is the monthly measure of risk tolerance along with the level of the S&P 500 index since 2007. Note that the two variables track one another closely. Here is another relevant figure from the presentation:

This figure shows the P/E ratios of the stock market for different reported levels of risk tolerance. We can observe that stock markets are more overvalued at times when people reported the highest level of risk tolerance.

The implications of what is shown in these two pictures is important. It suggests that risk tolerance surveys could cause people to "buy high and sell low."  When stock markets are performing well, the risk tolerance survey will suggest that people are able to cope with more aggressive asset allocations. When stock markets are down, the survey will suggest that people are risk averse and need to use lower stock allocations. This is the exact opposite behavior of what would generally be expected to best serve investors.  

EDIT: Follow-up on the original blog post:
There has been some discussion of this on Twitter. Comments focus on the idea of risk tolerance vs. risk perception. This was also the matter that Michael Kitces was stressing during the Q&A at the conference. However, I'm struggling to understand how this is a defense of risk tolerance, as the measure is supposed to be about risk tolerance, not the perceptions of how much risk exist in the market. A risk tolerance measure should bypass perceptions to get to the underlying characteristics of the individual.

However, another argument I've heard which is more damning to the study described in the post is that the scales on the axes are grossly miscalibrated. The fluctuations in the risk tolerance measure are actually so small that they would have very little practical significance in their implications for asset allocation. Though the correlation to the S&P500 exists, the figures in the above blog post misrepresent that by making the fluctuations in risk tolerance seem much larger than they really are. This is an important point, but I'm not in a position to judge who is right without knowing more about how the risk tolerance measure is applied in practice to determine asset allocation.