Risk tolerance is a deeply personal trait. It shapes how we think, feel, and behave, and is a core part of our identity and psychology as investors. Yet, it’s notoriously difficult to measure this trait accurately. Despite this, risk-tolerance tools are commonplace in the industry. Many are built on shaky foundations, lacking scientific rigor or validation evidence. Advisors should choose a tool that leads to in-depth discussions to help clients understand themselves and the risks of investing.
Not All Risk Tools Are Created Equal
Most people rarely think about their risk tolerance, especially those who are new to investing. Risk tolerance is a continuous spectrum, from risk-averse to risk-seeking, reflecting how people deal with the inherent uncertainty in the world. That makes it difficult to measure: Risk tolerance can’t be assessed with a simple yes/no question. It can be hard for individuals to express their feelings about uncertainty meaningfully on a scale.
The two most common methods for assessing risk tolerance are:
- Stated Preferences Questionnaires: These ask people to self-report behaviors and attitudes. For example: “How do you respond when things go wrong financially?”
- Revealed Preferences Exercises: These present hypothetical choices or gambles. A sample question: “Would you prefer a guaranteed payoff of X, or a 50/50 chance of gaining Y (nothing otherwise)?”
Both approaches can be useful, though they have limitations as well. When thoughtfully designed and implemented, both of these kinds of questions can accurately measure people’s preferences in different contexts. They can produce profiles for specific situations, but that isn’t enough when it comes to measuring people’s risk preferences for investing.
A useful approach should also support meaningful conversations about risk, expectations, and behavior (both historical and anticipated). A good risk tool needs to be relatable as well as reliable. It should help advisors and clients find a language for discussions that promote understanding of the intangible probabilities of gains and losses that are inherent in investing.
That’s where stated preference questionnaires come out ahead. These questionnaires are much better at framing risk decisions and supporting investment discussions. Revealed preference exercises, on the other hand, can feel more like abstract games, or worse yet, time at a casino.
Games May Not Feel Real
Real-life risk decisions are emotional. They involve consequences that matter not only for oneself but for loved ones as well. Abstract questions using gambling terminology may disconnect people from the natural emotions around investing. Hypothetical gambles can look more like math problems than a springboard for emotional insight. Moreover, many people find math off-putting and even stressful at the extreme. Using an exclusively numerical lens for an assessment may be a disservice for people unaccustomed to, or uncomfortable with, thinking in bets.
We know risk tolerance is shaped by cumulative life experiences. While new events can influence it, changes tend to be gradual. Tools that focus only on current preferences in isolated contexts miss the emotional depth of past experiences and may misrepresent the underlying trait. Ultimately, risk tolerance measures should help people find their emotional comfort, balancing the thrill of gains with the anxiety of losses. Questionnaires that explore a range of past and present scenarios, in a meaningful context, are more likely to capture this balance accurately.
This is an active area of research in the behavioral sciences. Some research shows that the choices people make in gambling hypotheticals are seldom consistent with choices they make when presented with real-life scenarios that have the same probabilities and pay-offs. More importantly, revealed preferences choices are less transferable to real-life risk decisions, they’re less likely to predict the level and persistence of actual risk-taking behavior and in some cases made the wrong predictions when compared to stated preferences tools. Lastly, estimating people’s risk preferences reliably is a notoriously difficult task that demands scores (or even hundreds) of questions. If taken seriously, this is not a quick-and-easy exercise.
Investing is Different Than Gambling
To support investors, risk measures must go beyond abstract exercises and reflect the emotional and contextual realities of investing and financial decision-making. Advisors need tools that foster understanding and insights. They need frameworks that help clients articulate their comfort with uncertainty and align the choices they make today with their long-term financial goals. The best tools help people understand themselves so they can assess the risk involved in investing and make necessary trade-offs. In a world of enduring market uncertainty, that understanding is the most valuable asset of all.
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