Our risk tolerance questionnaire is designed to be simple, yet captures all of the known relevant demographic and behavioral variables associated with investor risk tolerance. In addition to commonly used demographic factors like age and income, our questionnaire captures variables such as job title, industry and tenure with current employer, expected changes in income, and the amount of time the individual spends managing their investments. Choice of occupation is partly a financial decision and research suggests it provides important clues about investment risk attitude. Our own studies suggest that occupational factors and income expectations (rather than current income) are so important that you would have a better idea of someone’s investment risk tolerance knowing only these factors than if you knew the person’s age, gender, education, current income, and wealth.
Our method of measuring risk tolerance builds on the strengths of demographic profiling and subjective questionnaires while mitigating the flaws of each method when used in isolation. The demographic profiling aspect of our assessment is bolstered by the more complete set of variables captured by our questionnaire. In addition, the questionnaire includes subjective risk questions. However, we don’t take the responses to these subjective questions at face value, unlike other risk tolerance assessment systems.
Most risk assessments include subjective risk tolerance questions that offer responses in the form of a Likert-type scale (e.g., strongly disagree, disagree, neutral, agree, or strongly agree with a given statement) or offer some range of choices given a hypothetical financial scenario (e.g., if the stock market fell 30% would you a) buy more, b) do nothing, or c) sell everything!). Research has demonstrated that subjective risk tolerance questionnaires produce biased results influenced by how respondents think they should be answering questions rather than what their innate desires would otherwise dictate. In addition, studies have shown that subjective risk scores vary over time due to certain factors such as significant changes in equity prices.
To address these flaws, ArcPoint uses a baseline dataset to predict an individual’s response to the subjective risk questions based on their responses to the questions which are less susceptible to bias. An individual’s risk score is not determined only by their questionnaire responses, but reflects the average subjective question responses of otherwise similar individuals. We believe this "wisdom of the crowd" approach produces a superior assessment of an individual’s risk tolerance. This belief is supported by our proprietary research indicating that our crowd-sourced risk score does a better job of explaining an individual’s actual investment behavior than a risk score based solely on the individual’s own responses.
Most risk tolerance assessments produce a risk score and then leave it to the advisor to figure out what to do with it. Our risk score directly translates into a measure of relative risk aversion - the key ingredient in determining which portfolio is best for a particular investor. The subjective risk questions related to portfolio choice, job choice and a hypothetical gamble were designed to offer the respondent a series of choices between risk-free and risky alternatives, and the choices made correspond to various degrees of relative risk aversion.