INVESTMENT RISK PROFILING

A GUIDE FOR FINANCIAL ADVISORS

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ISBN: 978-1-942713-92-0
INVESTMENT RISK PROFILING
A GUIDE FOR FINANCIAL ADVISORS

CONTENTS

Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
The Investment Risk Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
A Framework for the Construction of an Investment Risk Profile . . . . . . . . . . . . . . . . . . . . . . . . 4
Factor 1 of 3: Establishing an Investor’s Risk Need . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Factor 2 of 3: Establishing an Investor’s Risk-Taking Ability . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Factor 3 of 3: Establishing an Investor’s Behavioral Loss Tolerance . . . . . . . . . . . . . . . . . . . . . . 8
Reconciling and Relating the IRP to a Portfolio Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Appendix A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Assessing and Choosing a Risk-Tolerance Measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Checklist for Evaluating Risk-Tolerance Measurement Tools . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Appendix B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Regulatory Background and Risk-Profiling Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Appendix C . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Risk-Profiling Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Appendix D . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Green Light Profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Yellow Light Profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Red Light Profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Case Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Case One . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Case Two . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

CE Qualified This publication qualifies for 1 CE credit under the guidelines of

Activity the CFA Institute Continuing Education Program.
EXECUTIVE SUMMARY

Establishing an investment risk profile (IRP) is an a calculated required portfolio RoR will suggest
essential part of structuring an investor’s investment potential asset allocation strategies that align with
portfolio, and the IRP is an integral element of an market risks.
investor’s investment policy statement. Financial • An investor’s ability to take risk includes the
advisors must use their best professional judgment investor’s time horizon, potential need for liquidity,
to determine how investors can achieve financial and risk capacity. These factors will determine the
goals through appropriate portfolio security selection. investor’s financial ability to withstand declines in
However, doing so requires balancing return objectives portfolio values. The ability to take risk can often
with the risk of variation in returns—in particular, the be a limiting factor when considering an investor’s
risk of negative returns. need for risk to meet corresponding goals.
Current financial advisor practices vary significantly • An investor’s behavioral loss tolerance can upset
and, with the advent of new digital tools, often revolve the most carefully devised quantitative portfolio
around a single characterization of an investor’s “risk strategy. Best practice is to use psychometric
tolerance” and/or a similar summary characterization tools (often questionnaires) that have
of an investor’s appetite for portfolio risk. In addition, demonstrated reliability and validity in predicting
although current regulatory guidelines require a an investor’s emotional and behavioral tendencies
consistent process for compliance, prescriptive around loss of portfolio value and investing
standards for how and in what manner IRP data should discipline.
be measured or applied are lacking.
Having independently analyzed the three dimensions
An important financial advisory skill is the ability that comprise an IRP—risk need, risk-taking ability,
to develop a comprehensive representation of and behavioral loss tolerance—the financial advisor
an investor’s IRP. A robust IRP measure provides must then reconcile these dimensions into a portfolio
a pathway to ensure that any proposed portfolio consistent with the investor’s IRP. This report
strategy is fit for the purpose with respect to achieving proposes best practices with regard to investment
an investor’s goals. This requires careful analysis and risk profiling: Financial advisors should strive to
synthesis of three dimensions of an IRP: combine straightforward calculations of risk need,
careful assessment of risk-taking ability, and a robust
• An investor’s need for risk should be assessed
examination of investor behaviors and attitudes to
by considering the required rate of return (RoR)
create the foundation for portfolio strategies and
on the investment portfolio to fulfill the investor’s
accompanying investment and financial planning
future lifestyle, charitable, and dynastic goals.
decisions.
In concert with capital markets expectations,

CFA Institute | 1
INTRODUCTION

At the heart of the relationship between financial and law (Appendix B provides additional details
advisors and their clients is the process by which a about the regulatory environment). Under common
client’s current financial state is related to the client’s law standards, financial advisors are expected to
investment aspirations for the future. The value of ensure that investors are aware of the potential
current assets, future savings and spending, and risks risks associated with available options. Less well
undertaken to achieve desired investment returns prescribed, however, are how investor information is
work together to shape the success or failure of goal obtained and how that information is presented to
achievement. When working with investors, financial investors. This has created an environment in which
advisors face the following complex dilemma: Given the use of risk-profiling tools varies dramatically from
that reward is not possible without risk, just how much one advisor and firm to another, as do the subsequent
risk is appropriate? portfolio recommendations.
Because of repeated episodes of misconduct, Given the gap in practice standards, numerous
regulators globally have been taking steps to commercial firms have entered the risk-tolerance
require firms and financial advisors to somehow and risk-profiling assessment marketplace.1 Some of
assess the risk-related attributes or “profile” of a these firms provide products that are intended to meet
prospective or current client when developing and minimum regulatory compliance requirements (i.e., the
justifying investment recommendations. Currently, investor risk profile provides a starting point in investor
the assumption is that as long as firms and financial discussions). Scores are generally presented on a
advisors can readily document a consistent evaluation numerical scale from very low to very high, but rarely
process, regulatory requirements will be met. However, are these scores defined in terms of an investment
uncertainty surrounds this assumption because few recommendation. Other firms provide more robust
standards or restrictions with respect to “how” to measures related to an investor’s IRP (investment
make a risk-profile assessment have been prescribed risk profile).
or enforced. For this reason, financial advisors have
Essentially, all “risk-profiling” tools in the marketplace
typically viewed the risk-profiling process primarily
can be used to meet regulatory customer due
as a regulatory hurdle. When conceptualized as a
diligence requirements.2 In addition, nearly all existing
threshold measure, rather than a tool to guide the
tools provide a basis for investor–advisor risk–return
development of a portfolio strategy and financial
discussions. As a result, financial advisors who are
recommendations, the risk-profiling documentation
merely looking for a regulatory compliance tool have
requirement has been met using short risk-tolerance
access to multiple alternatives.
questionnaires and assessment tests along with, at a
minimum, an acknowledgment of an investor’s age and The purpose of this report is to present a framework
financial circumstances. of best practices that financial advisors, educators,
and regulators can use to specify, measure, and
What makes matters even more confusing for
evaluate objective and behavioral factors unique to an
the typical financial advisor is that no recognized
investor, which can then be assessed and combined
regulatory body imposes specific guidelines regarding
into an IRP. This report provides a methodology that
how the results of a risk profile should be directly
financial advisors can follow to guide the development
applied to portfolio recommendations. In most
of investment portfolio strategies that reconcile an
jurisdictions, common law gives broad discretion
investor’s goals, assets, savings, and willingness
to financial advisors using their professional
to assume risk, affirming the intent of regulatory
judgment, which is a similar standard applied in other
requirements and improving investor outcomes relative
professional activities, such as medicine, accounting,
to each investor’s investment goals.

1
Nearly all broker/dealers and custodians require advisor staff to use in-house–developed risk-profiling tools.
2
Regulators have not historically prescribed validity, reliability, design, or interpretation guidelines related to risk-profiling tools, making nearly
all risk-tolerance and risk-profiling assessment tools, by default, compliant with regulations.

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Investment Risk Profiling

THE INVESTMENT RISK PROFILE Each of these elements—need, ability, and behavioral
loss tolerance—plays a distinct role in shaping how
The primary purpose of the risk-profiling process fast someone drives. One factor alone is insufficient
is to ensure that investment and financial to predict a trip’s characteristics. The combination
recommendations match an investor’s financial of driver, car, and environmental characteristics is
and emotional aptitude to engage in financial what shapes the driving profile of each trip. Similarly,
transactions, at the household level, that entail multiple factors must be combined in the development
financial/investment risk. of an IRP.

We begin by presuming that a financial advisor collects Financial advisors use an analytical process to
necessary objective and behavioral information from evaluate what level of portfolio risk (e.g., often
and about an investor with the intention of making simply volatility as measured by standard deviation
investment recommendations that are always in or its derivative, with more sophisticated downside
the investor’s best interests and that align with the measures and/or value at risk calculations increasingly
investor’s IRP. common) is appropriate for a particular investor.
Conventional wisdom and practice standards, based
When viewed from this perspective, the use of an IRP on heuristic models, often lead financial advisors
is analogous to deciding how fast to drive a car: to base investment and portfolio recommendations
• Before embarking, a driver makes a mathematical primarily on an investor’s age, so a younger investor is
estimate of how long the journey will take, and generally encouraged to take more risk, whereas an
thus how fast she or he needs to drive to arrive at older investor, all else being equal, is positioned to take
the appointed time. less risk.
• At the same time, the driver applies subjective However, the use of just one investor characteristic,
probabilities to assess the severity and such as age, can lead to improper alignment of an
consequences of arriving late. investor’s need, ability, and behavioral loss tolerance
• Along the way, the driver faces limitations with associated with taking investment risk. Risk need,
respect to how fast her car can actually go; this the ability to take risk, and the behavioral tolerance
ability factor is equivalent to a regulatory speed to engage in risk-taking activities often exist
limit, the amount of fuel the car has, and the traffic contradictorily within a single investor. An investor’s
conditions the driver encounters. risk need, ability to take risk, and behavioral loss
tolerance are also subject to change based on investor
• Finally, the driver’s behavioral preferences come and environmental circumstances.
into play; some drivers, for instance, get a thrill out
of driving aggressively, regardless of the possible Conceptually, the elements comprising an IRP can
consequences of being pulled over by law be grouped according to three factors. As shown in
enforcement or getting in an accident, whereas Figure 1, these factors are (1) risk need, (2) risk-taking
others prefer a more cautious journey. ability, and (3) behavioral loss tolerance.

FIGURE 1.  IRP FACTORS AND RELATED ELEMENTS

Risk Need Risk-Taking Ability Behavioral Loss Tolerance

• Required Rate of Return (%) • Time Horizon • Risk Tolerance
• Market Risk Environment • Need for Liquidity • Risk Preference
• Consequence of Failure • Risk Capacity • Financial Knowledge
• Investing Experience
• Risk Perception
• Risk Composure

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Investment Risk Profiling

A FRAMEWORK FOR Factor 1 of 3: Establishing

an Investor’s Risk Need
THE CONSTRUCTION OF AN
INVESTMENT RISK PROFILE
What follows is a description of each factor in the risk- • Required Rate of Return (%)
• Market Risk Environment
profiling process (as illustrated in Figure 1), a review of • Consequence of Failure
the elements comprising each factor, and an example
of how a financial advisor can measure/evaluate each
element. This is followed by an explanation of how the Risk Need
factors can be combined into a comprehensive IRP for
use in making portfolio allocation recommendations. The first factor comprising an IRP is related to
Two points are worth noting: establishing investor goals and the required return
• In the context of this report, risk refers to the needed to grow or preserve current assets to
degree of potential financial loss inherent in fund future goals. Essentially, this step in the IRP
an investment decision, generally measured development process is equivalent to relating a
by downside portfolio standard deviation or a required rate of return (RoR) to capital markets
derivative of standard deviation (i.e., volatility). expectations and thus potential portfolio risk. Often,
Uncertainty refers to a situation in which a an investor may need assistance from a financial
decision maker lacks information about known advisor to develop required returns and associated
probabilities before making a decision. For risk needs, which can include jointly developed
example, investment decisions are uncertain, assumptions regarding how long the investor will work,
whereas gambling decisions involve risk. Investors how much the investor will save or spend yearly, and
tend to be more averse to uncertainty than to whether the investor has a desire to leave a bequest
risk. As a result, investors are apt to act based on for his family or a charity. The required RoR estimate
perceptions of risk rather than on actual risk.3 can be objectively measured using one or more
• Although researchers, risk-profiling firms, and present/future value calculations. Alternatively, some
regulators have taken steps to standardize risk- financial advisors may choose to take a balance sheet
profiling terms and definitional guidelines, to date, approach and characterize the present value of assets
reaching a general consensus about risk-profiling (including discounted future cash flows) and the
terminology has been challenging. The definitions present value of liabilities (investor goals).
used in this report (see Appendix C) are based In the context of an IRP, one should note that for an
on the work of researchers across the finance, investor to express more than one financial goal is
financial planning, psychology, and business not unusual. Rather than aggregating investor goals,
management fields.4 the framework presented in this report treats each
goal separately, which implies that a financial advisor

3
Michael Joseph Roszkowski and Geoff Davey, “Risk Perception and Risk Tolerance Changes Attributable to the 2008 Economic Crisis: A Subtle
but Critical Difference,” Journal of Financial Services Professionals 64, no. 4 (July 2010): 42–53.
4
See the following sources:
Shawn Brayman, Michael Finke, Ellen Bessner, John Grable, Paul Griffin, and Rebecca Clement, Current Practices for Risk Profiling
in Canada and Review of Global Best Practices (Toronto: Investor Advisory Panel of the Ontario Securities Commission, 2015).
http://www.osc.gov.on.ca/documents/en/Investors/iap_20151112_risk-profiling-report.pdf.
Nicholas Carr, “Reassessing the Assessment: Exploring the Factors That Contribute to Comprehensive Financial Risk Evaluation”
(PhD diss., Kansas State University, 2014).
A. Hubble, “The Amalgamation of Professional Judgement: A Mean–Variant Approach from an International Survey of Financial Advisers”
(PhD diss., University of Georgia, 2018).
Liana Holanda Nepomuceno Nobre, and John E. Grable, “The Role of Risk Profiles and Risk Tolerance in Shaping Investor Decisions,”
Journal of Financial Service Professionals 69, no. 3 (May 2015): 18–21.
Liana Holanda, N. Nobre, John E. Grable, Wesley Vieira da Silva, and Fabio Chaves Nobre, “Managerial Risk Taking: A Conceptual Model
for Business Use,” Management Decision 56, no. 11 (2018): 2487–2501. https://www.emeraldinsight.com/doi/pdfplus/10.1108/
MD-09-2017-0892.

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Investment Risk Profiling

should estimate a unique IRP for each goal. This risk- profile is helpful in ensuring that an appropriate match
profiling approach is based on the mental accounting is made between portfolio recommendations and the
observations of Richard H. Thaler5 and others,6 which investor’s goal(s).
suggest that investors will have a distinct risk profile
based on a specific goal. The goal should be stated Market Risk Environment
specifically and in measurable terms as a pathway to
estimating an RoR or internal rate of return necessary The current market interest rate and inflation
to accomplish each account/goal. environment must also be evaluated when finalizing an
investor’s risk need. A financial advisor’s assessment
The goal at this stage of the risk-profiling process of the current and future market environment can play
is to assess the risk an investor needs to take (or an important role in shaping portfolio development
the volatility an investor must be willing to endure) and allocation decisions. Factors that contribute to
to achieve the goal.7 The risk-need factor comprises an assessment of the market environment include
three elements: (1) required RoR (%), (2) market risk current equity, fixed income, and cash/cash equivalent
environment, and (3) consequence of failure. Each returns compared with historical averages, current and
element is described as follows: projected inflation, and other factors that shape the
risk premium an investor faces. Although these and
Required RoR other components can be quantified, financial advisors
commonly apply professional judgment and models
As conceptualized in this report, the required RoR
when evaluating the market environment. As part of
is synonymous with risk need, which refers to the
the risk-profiling framework presented in this report, an
amount of portfolio risk an investor must accept to
advisor should assess whether the investor’s required
meet a specific financial goal. Typically, risk need is
RoR is realistic, given capital markets expectations,
expressed in terms of a real net (after inflation and
and when appropriate adjust the goal(s) and/or revisit
fees) RoR or internal RoR figure.
assumed savings rates.
For example, assume an investor has a goal of
accumulating $3.5 million at the end of 20 years. If the Consequence of Failure
investor can save $75,000 annually, the investor needs
to earn approximately 8.18% on an annualized basis to The third element when assessing a goal is
reach her goal. In this example, the investor’s risk need consequence of failure. Risk consequence refers to the
corresponds to a portfolio with an expected annual financial and emotional threats an investor faces if a
return of 8.18% and expected volatility derived from goal is not achieved. For example, some investors may
capital markets expectations, including volatility and consider that ensuring sufficient capital is available
correlation of returns among asset classes. to pay for a grandchild’s college education is a goal
with an acceptable consequence of failure, whereas
In nearly all cases, the estimation of a risk need is a others might consider that not achieving this goal is
quantifiable step in the risk-profiling process that is unacceptable. Goal consequence, therefore, is a key
well within the capability of most financial advisors element in determining how much portfolio risk is
using modern financial planning software and/or a appropriate to recommend.
spreadsheet analysis. In some situations, however,
an RoR estimate may not be an appropriate measure The consequence of failing to meet an investor’s goal
of risk need. Consider, for example, an investor with is not specifically quantified within the risk-need factor.
a net worth of $35 million whose primary goal is However, when combined with an investor’s ability to
capital preservation in relation to a later-life charitable take risk and her behavioral loss tolerance (defined
bequest. This investor’s risk need may be low in in detail later in this report), the severity of failing
relation to cash flow needs, primarily because the to meet a goal should be accounted for using the
investor has the risk capacity to deal with portfolio financial advisor’s judgment as to whether the advisor
losses. Nonetheless, estimating the investor’s risk should “nudge” an investor toward a higher volatility

5
Richard H. Thaler, “Mental Accounting and Consumer Choice,” Marketing Science 4, no. 3 (Summer 1985): 199–214.
6
See Jean L. P. Brunel, “Revisiting the Asset Allocation Challenge through a Behavioral Finance Lens,” Journal of Wealth Management 6, no. 2
(January 2003): 10–20; Dan Nevins, “Goals-Based Investing: Integrating Traditional and Behavioral Finance,” Journal of Wealth Management
6, no. 4 (Spring 2004): 8–23; and Franklin J. Parker, “The Erosion of Portfolio Loss Tolerance over Time: Defining, Defending, and Discussing,”
Journal of Wealth Management 19, no. 2 (July 2016): 23–31.
7
Categorizing the risk need as low, moderate, or high is used throughout this report to describe, in simple terms, how a risk profile can be
developed for an investor. These categories can be expanded, depending on a financial advisor’s business model.

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Investment Risk Profiling

portfolio than what her behavioral loss tolerance

TABLE 1. FRAMEWORK FOR ESTABLISHING
would otherwise allow, assuming the investor has the
AN INVESTOR’S RISK NEED (CONTINUED)
financial ability to deal with the magnitude of potential
losses associated with the risk need.   4. What is the time horizon for accomplishing
For example, assume an investor’s RoR need is 8.18%, stated goal (years)?
which in nearly all cases would be classified as a   5. What is the regular saving to (+)/spending from (–)
high risk need. If the consequence of failure is high, the account?
a financial advisor should present different scenarios
and trade-offs associated with taking more portfolio   6. What is the frequency of saving/spending
risk and failing to meet the goal. Perhaps other (monthly/quarterly/yearly/occasionally)?
solutions exist that will meet the investor’s needs,
  7. What is the estimated required RoR (%) to meet
such as (1) saving more, (2) spending less, (3) working
stated goal?
longer, or (4) reducing a bequest that could better
align the investor’s risk need with his behavioral risk   8. Given capital markets expectations and the
tolerance. current market risk environment, is this RoR
realistic to obtain?
Simplifying the Process   9. DECISION POINT:
Financial advisors may find that categorizing an • Proceed or stop and revise goal and/or
investor’s goal as low, moderate, or high risk (as savings rate.
measured by exposure to volatility) is useful, once
the required RoR has been estimated and the 10. Financial consequence of failing to meet stated
estimate has been confirmed through a market risk goal, if any:
environment analysis. The following guidelines can • Acceptable, unacceptable, unknown.
be used to classify a risk need:

Portfolio Composition Factor 2 of 3: Establishing an

of Growth Assets Investor’s Risk-Taking Ability
Necessary to Meet Risk-Need
RoR (%) Categorization
Less than 30% LOW
• Time Horizon
• Need for Liquidity
Between 30% and 70% MODERATE • Risk Capacity
Greater than 70% HIGH
Risk-Taking Ability

Risk Need Summary

An investor’s risk-taking ability encompasses three
The questions and tasks shown in Table 1 can be used elements: (1) goal time horizon, (2) need for liquidity,
to help guide the risk need estimation process for a and (3) risk capacity (i.e., capacity to deal with a
given future goal. financial loss).

Goal Time Horizon

TABLE 1. FRAMEWORK FOR ESTABLISHING Not only is an investor’s goal time horizon an input
AN INVESTOR’S RISK NEED used to determine the risk need (i.e., the required RoR
  1. What is the investor’s goal? need), but it is also an important element describing
risk-taking ability. Conceptually, the goal time horizon
  2. What is the future value need ($)? is the period between when a goal is established
and the date of that goal’s achievement, which in
  3. What is the present value of investment
some cases may exceed the investor’s remaining
account ($)?
lifetime. All else being equal, investors with long goal
(Continued) time horizons have a greater capacity to withstand

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Investment Risk Profiling

and recoup portfolio losses resulting from market Risk Capacity

volatility, compared with investors with shorter goal
time horizons. Financial advisors should account for Risk capacity refers to an investor’s financial
an investor’s goal time horizon when applying their capability to withstand a financial loss without
professional judgment with respect to the investor’s meaningfully compromising her desired standard of
ability to take risk. living. Risk capacity is often evaluated using objective
investor characteristics. For example, risk capacity
can be gauged by total investable assets relative
Simplifying the Process to net worth and the amount of outside assets or
Financial advisors may find that classifying an income available to the investor to cover future or
investor’s goal time horizon as follows is useful in unexpected liabilities. If an investor has adequate
the risk-profiling process: cash savings, pension income, insurance, and/or
access to credit to cover his standard-of-living needs
• An investor is deemed to have a short goal time
should an unexpected loss occur as the result of an
horizon if the time needed for goal achievement
emergency or a market decline—without significantly
is five years or fewer.
relying on or affecting the value of portfolio assets
• An investor is deemed to have a long goal time dedicated to achieving investor goals—the investor
horizon if the time needed for goal achievement would be considered to have a high risk capacity.
is 10 years or more. If, however, a significant drop in portfolio value could
• A goal time horizon that falls between these compromise the investor’s standard of living, the
two points is defined as an intermediate time financial advisor should consider the investor’s risk
horizon. capacity low.
Consider an investor with a long goal time horizon,
Need for Liquidity low need for liquidity, and high degree of wealth
or outside sources of income in relation to daily
Need for liquidity is defined as an objective standard-of-living needs. This type of investor would
requirement or desire to hold cash for ongoing current generally be considered to have a high ability to take
or future expected distribution needs. During the financial risk. All else being equal, recommending a
capital accumulation phase of an investor’s lifespan, portfolio that has a risk (volatility) need greater than
liquidity needs may be quite low—which would the investor’s risk-taking ability allows would be
increase an investor’s ability to withstand market considered imprudent regardless of the investor’s
risk—whereas a liquidity need may be very high risk need or behavioral loss tolerance (described
during the capital distribution phase of an investor’s later in this report).
lifespan—thus reducing the investor’s ability to incur
investment risk. Financial advisors should account
for the investor’s need for liquidity when applying their
Risk-Taking Ability Summary
professional judgment with respect to the investor’s Although some subjectivity is involved, consideration
ability to take risk. of an investor’s goal time horizon, liquidity needs, and
capacity to take risk all inform a financial advisor’s
Simplifying the Process professional judgment about the investor’s risk-taking
ability. Note that the ability elements, more than
Financial advisors may find that classifying the the other IRP elemental factors, will change, often
investor’s need for liquidity is useful in the risk- significantly, throughout the goal timeline. These
profiling process, doing so using the following elements should be revisited whenever an investor’s
guidelines: situation (financial or otherwise) changes dramatically
• A net (after advisory fees) expected or ongoing and as the goal moves closer to completion, primarily
annual distribution need of 5% or more of because an investor’s ability to take risk generally
a portfolio’s value indicates a high liquidity declines as the goal nears.
need or a correspondingly low ability to take
financial risk. Simplifying the Process
• An absence of expected distributions indicates Financial advisors may find that classifying an
a low liquidity need or a correspondingly high investor’s risk-taking ability as follows is useful in
ability to take financial risk. the risk-profiling process:

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Investment Risk Profiling

element can be calculated using financial software,

If EITHER of the following situations is present, the spreadsheet packages, or a financial calculator
investor’s ability to take risk is LOW: with time value of money capabilities—elements
9 Time horizon is less than or equal to five years. of behavioral loss tolerance tend to be subjective
and unique to each investor. As such, an investor’s
9 The expected and/or ongoing annual liquidity behavioral loss tolerance must usually be inferred
need is greater than or equal to 5% of the from the administration of appropriately designed
portfolio value and no outside income or questionnaires, tests and scales, and conversations
assets (e.g., employment income, access to with the investor, as well as/or by examining the
credit, cash savings, insurance) are available investor’s past behavior with regard to asset allocation
to maintain standard of living in case of an decisions. Relying on just one of these inputs can
emergency. result in a skewed assessment of an investor’s
If ALL of the following scenarios are present, the emotional wherewithal to engage in risky financial
investor’s ability to take risk is HIGH: behaviors.
9 Time horizon is greater than or equal to In the context of the risk-profiling process described in
10 years. this report, an investor’s behavioral loss tolerance can
9 Investor has no expected and/or ongoing be described by six elements:
annual liquidity needs that are greater than (1) risk tolerance
5% of the portfolio value. (2) risk preference
9 Sufficient outside income or assets (e.g., (3) financial knowledge This is Knowledge game
current income, access to credit, cash
(4) investing experience
savings, insurance) are available to maintain
standard of living in case of an emergency. (5) risk perception
Otherwise, the investor’s ability is MODERATE. (6) risk composure
Unless a financial advisor is using a fit-for-purpose
behavioral loss tolerance questionnaire, each of these
Factor 3 of 3: Establishing an elements must be assessed independently.8 The
six elements comprising this factor are described in
Investor’s Behavioral Loss Tolerance greater detail in the following sections.

• Risk Tolerance Risk Tolerance

• Risk Preference
• Financial Knowledge Risk tolerance (i.e., willingness to take risk) represents
• Investing Experience
• Risk Perception
the maximum amount of uncertainty an investor is
• Risk Composure willing to accept when making a financial decision.9
Risk tolerance can also be conceptualized as an
Behavioral Loss
Tolerance investor’s inclination to engage in financial behavior
whose outcome is unknown and potentially negative.10
Risk aversion is the inverse of risk tolerance. In general,
Although, in general, the first two IRP factors are easily one can reasonably assume that an investor’s financial
measured with objective data points—that is, each risk tolerance is relatively stable across time.

8
The six elements comprising the behavioral loss tolerance factor tend to be highly correlated. This does not mean, however, that the
elements can be used as substitutes for each other. Just as income and net worth are highly correlated, measuring, say, income and
then assuming net worth based on the income assessment would be irresponsible. In this report, an investor (or her financial advisor) is
responsible for evaluating each of the six elements. How the exact assessment is made is a decision the financial advisor and/or the firm
must make. The risk-profiling methodology outlined in this report is assessment and product neutral. Appendix A provides an overview of
the concepts needed to effectively evaluate risk-tolerance and risk-aversion questionnaires. The information in Appendix A can also be
used to guide the choice of questions and questionnaires used to measure risk preference, financial knowledge, investing experience, risk
perception, and risk composure.
9
David M. Cordell, “RiskPACK: How to Evaluate Risk Tolerance,” Journal of Financial Planning 14, no. 6 (June 2001): 36–40.
10
The concept of risk tolerance is related to loss tolerance/aversion. Loss tolerance relates to prospect theory and the notion that people
weigh losing money more heavily than making money. When risk tolerance is viewed this way, an investor will establish a baseline portfolio
value level. The investor will then tolerate swings in the market so long as the resulting portfolio balance remains above the reference point.

8 | CFA Institute
Investment Risk Profiling

Numerous commercial firms provide financial risk-

tolerance evaluation and assessment platforms. The Simplifying the Process
two most common approaches used to measure risk Financial advisors may find that categorizing an
tolerance are psychologically derived risk-tolerance investor’s risk preference as follows is useful in the
questionnaires11 and economics-based revealed risk-profiling process:
preference tests.12 Appendix A provides a detailed
description of the questions a financial advisor should 1 = Maximize Safety; 2 = Mostly Safety;
ask before choosing a risk-tolerance questionnaire or 3 = Mix of Safety and Return; 4 = Mostly Return;
revealed preference test for use in the risk-profiling 5 = Maximize Return.
process this report describes.
Financial Knowledge
Simplifying the Process
Financial knowledge represents the combined financial
Financial advisors may find that categorizing risk information, facts, and skills an investor exhibits
tolerance as follows is useful in the risk-profiling and uses when making financial decisions. Financial
process: knowledge is gained through education, training,
1 = Very Low; 2 = Low; 3 = Moderate; 4 = High; and experience. In the context of risk profiling, an
5 = Very High. investor’s financial knowledge can be evaluated
multiple ways, including via assessments a financial
advisor makes after discussing broad financial topics
Risk Preference with the investor. A more precise estimate of financial
knowledge can be obtained by having an investor
Risk preference refers to an investor’s use of
complete a financial knowledge quiz during the data-
subjective and objective cognitive evaluations to
gathering phase of the investment management
describe her feelings regarding a real or potential
process. For example, the Financial Industry
course of action. For example, an investor may
Regulatory Authority (FINRA) Investor Education
prefer investing in certificates of deposit based
Foundation’s national financial capability study (www.
on subjective probability estimates that indicate a
usfinancialcapability.org/quizzes.php) has questions
minimal chance of losing money; another investor
that can be used for this purpose.14
may prefer to avoid certificates of deposit based on
a cognitive evaluation showing that the after-tax
and after-inflation returns associated with these Simplifying the Process
assets result in problematic outcomes. In nearly Financial advisors may find that categorizing an
all cases, investors prefer taking less risk.13 Keep investor’s financial knowledge as follows is useful
in mind that an investor may prefer a low volatility in the risk-profiling process:
investment or portfolio while also being willing to
invest more aggressively if the returns justify the 1 = Not at All Knowledgeable; 2 = Minimally
risks. Stated another way, an investor may prefer low Knowledgeable; 3 = Moderately Knowledgeable;
volatility investments while concurrently exhibiting a 4 = Competent; 5 = Very Knowledgeable.
willingness to take financial risk.

11
Financial advisors who are primarily interested in anticipating or predicting an investor’s future investment or financial behavior—after a
recommendation has been implemented—will find behavioral prediction tools valuable. Scores from these tools provide a forecast estimate of
future investor behavior during market corrections and other events.
12
These tools ask questions based on the economic concept of risk in which probability outcomes are predetermined. Resulting answers
to such questions can be used to derive a measure of constant relative risk aversion. Constant relative risk aversion can then be used to
estimate an investor’s utility curve. Where the utility curve intersects the efficient frontier then becomes the recommended portfolio.
13
Harry M. Markowitz, “Portfolio Selection,” Journal of Finance 7, no. 1 (March 1952): 77–91.
14
See Annamaria Lusardi and Olivia S. Mitchell, “Baby Boomer Retirement Security: The Roles of Planning, Financial Literacy, and Housing
Wealth,” Journal of Monetary Economics 54, no. 1 (January 2007): 205–224.

CFA Institute | 9
Investment Risk Profiling

Investing Experience with investing. Those who perceive little to no such

risk should exhibit greater adaptability in the face of
Investing experience refers to an investor’s mastery market volatility. Risk perception can be evaluated
of financial topics and skills obtained through based on a financial advisor’s discussions with an
action, behavior, or participation in financial and/ investor or by asking an investor how she or he feels
or investment activities. The relationship between about taking financial risks (e.g., “How risky is the
risk taking and experience is generally positive, with stock market?”).
those who exhibit modest to high levels of experience
being more likely to trade securities, purchase and
hold investment assets (including real estate), and
Simplifying the Process
save and borrow more aggressively. Few financial Financial advisors may find that categorizing an
experience questionnaires, scales, or measurement investor’s risk perception as follows—based on
tools exist. Within the financial risk-profiling framework the investor’s answer to the question “How risky is
presented in this report, financial experience can the stock market?”—is useful in the risk-profiling
be assessed using a financial advisor’s professional process:
judgment. A key element of this assessment should
1 = Very Risky; 2 = Somewhat Risky; 3 = Neutral;
be linked to the number of years the investor has been
4 = Somewhat Safe; 5 = Very Safe.
actively engaged in making financial decisions and/
or the number of investment and business cycles the
investor has experienced. Risk Composure
Risk composure refers to the likelihood that in a
Simplifying the Process perceived or actual crisis, an investor will exhibit
Financial advisors may find that categorizing an behavior fundamentally different from her past
investor’s investing experience as follows is useful actions.17 Investors with low risk composure tend
in the risk-profiling process: to act in a biased manner, which often results in
actions that crystalize losses. Risk composure can be
1 = None; 2 = Very Little; 3 = Some; 4 = Modest;
measured by evaluating an investor’s past decisions
5 = Extensive.
and actions.

Risk Perception Simplifying the Process

Risk perception refers to a judgment an investor makes Financial advisors may find that categorizing an
(feels) regarding the severity of risk in association with investor’s risk composure as follows—based on an
the broader economic environment. Risk perception investor’s answer to the question “In the past, when
can be influenced by the media and/or an investor’s faced with investment losses, what did you do?”—
lack of knowledge and experience. How an investor is useful in the risk-profiling process:
perceives the degree of risk associated with a
1 = Sold Investment (Low Risk Composure); 3 = Did
behavior is known to contribute to his engagement
Nothing (Moderate Risk Composure); 5 = Purchased
in risk-taking behavior.15 Risk perception is primarily a
More (High Risk Composure).
cognitive activity involving the appraisal of external
conditions and internal states.16 Generally, perception
of risk involves a subjective evaluation of potential Behavioral Loss Tolerance Summary
risk-taking outcomes.
Financial advisors should assess and evaluate each
As conceptualized in the risk-profiling process of these six elements to arrive at an estimation of an
described in this report, risk perception is linked to investor’s behavioral loss tolerance.
an investor’s judgment of the riskiness associated

15
Sim B. Sitkin and Amy L. Pablo, “Reconceptualizing the Determinants of Risk Behavior,” Academy of Management Review 17, no. 1
(January 1992): 9–38.
16
Michael Joseph Roszkowski and Geoff Davey, “Risk Perception and Risk Tolerance Changes Attributable to the 2008 Economic Crisis:
A Subtle but Critical Difference,” Journal of Financial Service Professionals 64, no. 4 (July 2010): 42–53.
17
David M. Cordell, “RiskPACK: How to Evaluate Risk Tolerance,” Journal of Financial Planning 14, no. 6 (June 2001): 36–40.

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Simplifying the Process

Table 2 provides a scoring sheet that can be used to evaluate the behavioral loss tolerance elements
described in this report and to derive an investor’s behavioral loss tolerance score.

TABLE 2.  BEHAVIORAL LOSS TOLERANCE SCORING SHEET

What is the investor’s risk tolerance or willingness to take financial risk? SCORE
Very Low Low Moderate High Very High
1 2 3 4 5
What is the investor’s preference when holding risky assets?
Maximize Mostly Mix of Safety Mostly Maximize
Safety Safety and Return Return Return
1 2 3 4 5
How knowledgeable is the investor about financial and investment concepts?
Not at All Minimally Moderately Very
Knowledgeable Knowledgeable Knowledgeable Competent Knowledgeable
1 2 3 4 5
How much experience does the investor have with investment products?
None Very Little Some Modest Extensive
1 2 3 4 5
What is the investor’s perception of the riskiness of the stock market?
Very Risky Somewhat Risky Neutral Somewhat Safe Very Safe
1 2 3 4 5
In the past, when faced with investment losses, what action did the investor take?
Sold Investment Did Nothing Purchased More
1 3 5

TOTAL

Scores for each of the elements comprising the behavioral loss tolerance factor should be summed. The total
scores possible for the factor range from a low of 6 to a high of 30. Scores should then be matched to the
following behavioral loss tolerance categories:
• LOW = 6 to 13
• MODERATE = 14 to 22
• HIGH = 23 to 30

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Investment Risk Profiling

RECONCILING AND RELATING • Higher risk-taking ability can be discounted when

both the risk need and behavioral loss tolerance
THE IRP TO A PORTFOLIO are lower.

STRATEGY EXAMPLE

Once the three factors of risk need, risk-taking ability, Risk- Behavioral
and behavioral loss tolerance have been assessed Risk Taking Loss Portfolio
independently, the financial advisor can develop an Need Ability Tolerance Strategy
IRP that will inform portfolio recommendations. The IRP
Low High Low Consistent with
is not only a qualitative assessment of an investor’s
Risk Need and
financial and emotional aptitude for engaging in
Behavioral Loss
transactions that involve risk but also a quantitative
Tolerance
assessment of an investor’s need for risk (usually
expressed as a required RoR to achieve goals) and
risk-taking ability (typically considered in the context
• Higher behavioral loss tolerance can be ignored
of drawdowns or volatility and related to the effect on
when both the risk need and risk-taking ability are
an investor’s standard of living).
lower; the advisor may need to coach the client to
The IRP may reveal conflicting factors that require overcome her behavioral tendencies to take risk
an advisor’s professional judgment to reconcile. The in light of the realities of the client’s risk need and
following decision rules can be used to guide the risk-taking ability.
interpretation of an IRP:
EXAMPLE
• The investor’s risk need cannot exceed the Risk- Behavioral
investor’s risk-taking ability associated with the Risk Taking Loss Portfolio
goal. Reconciling these two factors requires that a Need Ability Tolerance Strategy
financial advisor counsel the investor to reconsider
goals and/or savings rates. Low Low High Consistent with
Risk Need and
EXAMPLE Risk-Taking Ability

Risk- Behavioral
Risk Taking Loss Portfolio • Low behavioral loss tolerance can never be
Need Ability Tolerance Strategy ignored; however, a financial advisor may conclude
that appropriate client counseling and education
High Low High Reconsider Goals
can be used to “nudge” an investor into a higher-
risk portfolio when the risk need and risk-taking
ability are higher.
• A lower risk need can be discounted when both
risk-taking ability and behavioral loss tolerance are EXAMPLE
higher.
Risk- Behavioral
EXAMPLE Risk Taking Loss Portfolio
Need Ability Tolerance Strategy
Risk- Behavioral
Risk Taking Loss Portfolio High High Low Counseling and
Need Ability Tolerance Strategy Education
Low High High Consistent with
Risk-Taking Ability
and Behavioral
Loss Tolerance

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• A financial advisor should not recommend a

portfolio allocation that exceeds an investor’s
SUMMARY
risk-taking ability. Risk-taking ability sets an upper The current standard of practice of using a single risk
volatility bound to a portfolio recommendation. coefficient or data input as a guide to an appropriate
Because risk-taking ability changes (especially as portfolio choice (either within the context of modern
the goal time horizon shortens), this factor must portfolio theory or as a tool to select an advisor-
be reassessed regularly. developed portfolio) is likely flawed. Stated another
way, a single score derived from a risk-tolerance
EXAMPLE
questionnaire or revealed preference test, while useful
Risk- Behavioral in describing a broader risk profile, is not sufficient to
Risk Taking Loss Portfolio describe an investor’s risk need, risk-taking ability, or
Need Ability Tolerance Strategy behavioral loss tolerance.

Low Low High Consistent with Regardless of the approach used to develop portfolio
Risk-Taking Ability selection recommendations, financial advisors
face the real risk of failing to meet an investor’s
goal(s) if a selected portfolio is positioned either
Portfolio Implications of too conservatively or too aggressively. To increase
the likelihood of achieving investor goals, financial
IRP Categorizations advisors must use tools that fully inform professional
Throughout this report, documentation has been judgment when making portfolio allocation
made indicating where financial advisors may recommendations. The risk-profiling modelling process
simplify the process by categorizing elements this report describes helps move risk profiling away
of the three factors that make up an IRP. These from the measurement of one or a few data points
categorizations may be used to guide some while standardizing some of the elements and
financial advisors to appropriate portfolio decision points in the risk-profiling process.
recommendations. A process for categorization
based on the IRP development process described
in this report is presented in Appendix D.

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Investment Risk Profiling

APPENDIX A
Assessing and Choosing coefficient). Asking a questionnaire or test
developer for evidence of criterion validity before
a Risk-Tolerance Measure18 adopting a tool is appropriate. Two types of
The measurement of financial risk tolerance—an criterion validity are particularly important:
investor’s willingness to engage in financial behavior • Concurrent validity provides evidence that the
whose outcomes are unknown and potentially questionnaire or test score is associated with
negative—is typically conducted using one of other measures of financial risk taking.
two tools: ■ For example, a financial risk-tolerance
• a psychologically derived questionnaire score should be positively associated
with holding equities and negatively
• a revealed preference risk-aversion test
associated with holding cash and cash
Normally, financial advisors either use a commercial equivalent assets.
product or rely on a questionnaire developed in-house • Predictive validity provides evidence
to asses an investor’s tolerance for financial risk and that questionnaire or test scores provide
to meet regulatory requirements. Both approaches meaningful insight into future behavior.
offer unique advantages and disadvantages in terms
■ For example, scores should be predictive
of accuracy, repeatability, and overall validity. When
of who is more or less likely to react
deciding on an approach—and selecting a particular
negatively during a bear market.
risk-tolerance assessment tool—both the validity and
reliability of the tool should be considered.
“Red flags” that a question or questionnaire
might not be valid include the following:
Validity
Questions elicit risk tolerance outside the
Validity refers to how accurate a tool is in describing context of investment risk taking. These types
or predicting human trait factors, attitudes, or of questions do a poor job of predicting
behavior. Stated another way, “validity refers to how investment risk-taking behavior primarily because risk
well the assessment tool actually measures the tolerance tends to be domain specific and not a
underlying outcome of interest” (p. 119),19 in this generalized characteristic. The following is an example
case, an investor’s willingness to take financial risk. of a poor question:
For a questionnaire or test to be valid, scores must be
accurate in forecasting how an investor will respond I enjoy risky activities such as skydiving, motorcycle
in real-life financial situations. Two forms of validity are riding, and rock climbing.
especially important with respect to the choice of a • 1—Strongly Agree
financial risk-tolerance tool:
• 2—Agree
• Content validity: This assessment of validity • 3—Neutral
is based on the professional judgment of
• 4—Disagree
subject matter experts. The questions asked
in the questionnaire or test should appear, to a • 5—Strongly Disagree
professional, appropriate in terms of accurately Questions focus on having an investor
assessing an investor’s willingness to take a anticipate future behavior. Investors are
financial risk. A measurement tool should also generally unable to accurately assess their own
pass a financial advisor’s test of face validity, financial sophistication or future behavior, especially
which is an advisor’s feeling that the questions when asked during a market in which prices are
asked appear correct. generally increasing. These types of questions should
• Criterion validity: This assessment of validity is be avoided in favor of more objective questions. The
measured using a statistical test (e.g., correlation following is an example of a problematic question:

The authors wish to thank Dr. Michael Roszkowski for his comments on elements of this appendix.
18

Gail M. Sullivan, “A Primer on the Validity of Assessment Instruments,” Journal of Graduate Medical Education 3, no. 2 (June 2011): 119–120.
19

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If the stock market were to fall 30% over the next six Questions imbed complex language or
months, which would you choose to do? investment-specific verbiage. Words such as
“risky,” “volatile,” “aggressive,” and
• 1—Sell Immediately
“conservative” have different connotations in different
• 2—Do Nothing contexts. Words, terms, and phrases should be well
• 3—Buy More defined and understood within the context of a
question, and words should exhibit a consistent
Questions pose 50/50 chance outcome
magnitude for each scale response. Financial
choices. Investors are more likely to take a
abbreviations and acronyms, even well-known ones,
risk when the odds of success are known in
should be avoided. The following is an example of a
advance; however, financial and investment
complex language question:
outcomes are not known in advance, nor do typical
investment choices have 50/50 predetermined odds. How would you describe your preferred investment
All revealed preference tests use a series of 50/50 strategy?
outcome choice questions. These tests should be
• 1—Capital Preservation
approached with caution because responses may
not be valid. An example of a revealed preference • 2—Conservative
question follows: • 3—Balanced
Suppose that you are about to retire and have • 4—Risky
two choices for a pension. Annuity A gives you an • 5—Maximize ROI
income equal to your preretirement income. Annuity
Questions are double-barreled. Questions
B has a 50% chance your income will be double your
should be framed to assess just one concept
preretirement income and a 50% chance that your
or issue because with “double-barreled”
income will be 20% less than your preretirement
questions, the investor could both agree and disagree
income. Which annuity would you choose?
simultaneously, which then forces the investor into a
Questions bias an investor. A common guessing situation. The following is an example of a
problematic question is one in which an double-barreled question:
illustration is provided showing how an investor
Please agree or disagree with the following statement:
should respond or how others (particularly experts or
I am financially knowledgeable and experienced.
peers) most often respond. This type of question may
bias an investor to respond with what she or he • 1—Agree
believes is the “correct” answer rather than how the • 2—Disagree
investor truly feels. The following is an example of a
biased question:
Reliability
Many financial experts recommend that the percentage
Of equal importance when selecting a risk-tolerance
of equity securities in your portfolio should be equal
assessment tool or questionnaire is documentation
to 100 minus your age. What percentage of equity
of reliability. Reliability refers to whether a tool or
securities would you be comfortable investing?
questionnaire generates the same results each time it
• 1—0–20% is used in the same setting with the same person. For
example, a person’s scored outcome should be similar
• 2—21–40%
in periods of market stress and market expansion. If a
• 3—41–60% questionnaire or measurement tool is not reliable, the
approach is, by definition, invalid.
• 4—61–80%
The measurement of reliability is based on a statistical
• 5—81–100%
test. Reliability is most often measured as internal
consistency between and among items asked in a
questionnaire. Questionnaires and scale developers
commonly report reliability as Cronbach’s alpha.20

20
Traditional measures of reliability have been criticized as being inadequate. Alternatives to Cronbach’s alpha include omega and the greatest
lower bound. See Gjalt-Jorn Ygram Peters, “The Alpha and the Omega of Scale Reliability and Validity: Why and How to Abandon Cronbach’s
Alpha and the Route towards More Comprehensive Assessment of Scale Quality,” European Health Psychologist 16, no. 2 (April 2014): 56–69.

CFA Institute | 15
Investment Risk Profiling

Another form of reliability is based on test-retest data. the number of questions asked, the more
This estimate of alpha is derived by comparing a test accurate the results of the assessment
taker’s score on the same questions from one period to are likely to be. (p. 47)
that from another period. From a due diligence point of
While the optimal number of questions is still a matter
view, a questionnaire or test should exhibit a reliability
of preference, an appropriate range is between 7 and
score of 0.70 or higher.
30 items.
• Asking a risk-tolerance questionnaire developer
Another problem observed in many risk-tolerance
to provide evidence of reliability is a best
questionnaires is an attempt to blend subjective
practice. Reliability will generally be reported as
behavioral tolerance questions with objective
Cronbach’s alpha (a). Scores of a  0.70 indicate
questions relating to an investor’s need and ability
that the questionnaire is more likely to generate
to take risk. For a questionnaire to ask about time
consistent, dependable, and meaningful results
horizon, age, liquidity need, and risk capacity is
across time and across investors.
common. Although each of these elements is crucial
to developing an overall risk profile, subjective
A Note on Psychologically Derived and objective elements should not be averaged
Questionnaires together within a weighting methodology. This ad hoc
commingling of subjective and objective questions
Numerous firms provide risk-tolerance (risk-aversion)
can lead to an over- or underweighting of subjective
assessment platforms for use when assessing an
behavioral factors relative to objective factors. Time
investor’s willingness to take financial risk, and most
horizon and risk capacity questions should generally
are administered via a series of scale questions in
not be included in a risk-tolerance questionnaire or test.
which a single “score” is estimated. In the context of
this report, a questionnaire that includes questions Overall, the use of a psychometrically valid and reliable
related to all six elements of the behavioral loss risk-tolerance questionnaire is the preferred method
tolerance factor of the risk-profiling process would be for measuring an investor’s risk tolerance—one of the
beneficial.21 Unfortunately, few such questionnaires six elements comprising an investor’s behavioral loss
exist. Instead, those who use the risk-profiling process tolerance; however, financial advisors and regulators
described in this report will need to choose a risk- must be cognizant of the common theoretical
tolerance questionnaire and supplement the derived problems observed in both commercial and in-house
score with data representing the other elements. firm-developed questionnaires and be able to identify
and discern the good tools from the bad.
When evaluating a particular risk-tolerance
questionnaire or test, understanding the validity
and reliability characteristics of the questionnaire or A Note on Measures of Revealed
test, as has been described, is important. Another Preference
factor to consider is the length of the risk-tolerance
assessment. How many questions a questionnaire As noted earlier in the text, two types of risk-
or test should include is a matter of some dispute. tolerance assessments are widely used in practice:
Financial advisors and investors prefer fewer psychologically derived questionnaires and revealed
questions; however, researchers, in general, argue preference risk-aversion tests. The evaluation of
that asking more questions helps increase validity and a revealed preference test requires additional
reliability, making scores more accurate. As Michael due diligence.
Joseph Roszkowski explains,22 Although sometimes presented in questionnaire
Only by presenting the investor with a format, measures of revealed preference are
sufficiently large number of questions can generally not developed in the same manner as
you hope to get a representative sample a psychologically derived scale. Tools based on
of past behaviors, current attitudes, and psychological theory almost always combine
intentions regarding the future. The greater responses across questions when calculating
a score.23 Revealed preference measures,

21
These elements are willingness to take financial risk, risk preference, financial knowledge, financial experience, risk perception, and risk
composure (past behavior).
22
Michael Joseph Roszkowski, “How to Assess an Investor’s Financial Risk Tolerance: The Basics,” in Personal Finance Risk Tolerance
(Bryn Mawr, PA: The American College, 1992).
23
This is sometimes referred to as a summated scale.

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FIGURE A1.  EXAMPLE OF REVEALED PREFERENCE TEST

Are you willing to

lose 1/3 of your income
for a chance of doubling
your income?

No Yes

Are you willing to Are you willing to

lose 1/5 of your income lose 1/2 of your income
for a chance of doubling for a chance of doubling
your income? your income?

No Yes No Yes

Least Somewhat More Most

Risk Tolerant Risk Tolerant Risk Tolerant Risk Tolerant

like the example shown in Figure A1, rely on skip- Conclusion

pattern responses.24
To review, the first step when selecting a risk-
When enough items are asked and responses from tolerance measure involves conducting a validity
the answered items analyzed, estimates of constant review. Essentially, this means determining whether
relative risk aversion (the inverse of risk tolerance) the questions included in a questionnaire or test,
can be derived. Constant relative risk aversion can and the resulting output, “look” and “feel” right. This
then be used to estimate an investor’s utility function is not always a statistical test but sometimes an
in the context of portfolio selection along the efficient assessment based on professional judgment. Once
frontier. In the risk-profiling methodology presented in one or more potential questionnaires have been
this report, however, a revealed preference score is not identified for potential use in the risk-profiling process,
intended to be used in isolation. Instead, scores from a the following checklist can be used to refine the risk-
revealed preference test should, as Alessandro Bucciol tolerance questionnaire decision choice.26
and Marina Stuefer note, be used in the risk-profiling
process as a proxy for financial risk tolerance or as an
“indicator of self-assessed risk attitude” (p. 23).25 Checklist for Evaluating Risk-
Tolerance Measurement Tools
Before selecting a revealed preference measure, asking
the test developer about the tool’s validity and reliability • The questionnaire developer’s website or marketing
is important, as is keeping in mind that given the way material documents questionnaire validity.
questions are presented in most revealed preference • The questionnaire developer’s website or marketing
tests, a reliability estimate using a traditional estimate, material documents questionnaire reliability via
such as Cronbach’s alpha, may not be available. test-retest scores or Cronbach’s alpha (a ³ 0.70).
Instead, a test developer should provide a reliability • The questionnaire includes a variety of questions
estimate based on test-retest data (i.e., an illustration and scenarios (minimum of seven questions)
of test scores by the same person over time).

24
The questions in Figure A1 are from Robert B. Barsky, F. Thomas Juster, Miles S. Kimball, and Matthew D. Shapiro, “Preference Parameters and
Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study,” Quarterly Journal of Economics 112 (May 1997):
537–579.
25
Alessandro Bucciol and Marina Stuefer, “Measuring Household Financial Risk,” Journal of Wealth Management 15, no. 3 (Winter 2012): 20–29.
26
Adapted from Michael Joseph Roszkowski, Geoff Davey, and John E. Grable, “Insights from Psychology and Psychometrics on Measuring Risk
Tolerance,” Journal of Financial Planning 18, no. 4 (April 2005): 66–77.

CFA Institute | 17
Investment Risk Profiling

that relate to the type of product or service being have a reasonable basis to believe that a
offered (e.g., investing, savings choices, business transaction or investment strategy involving
ownership). securities that are or have been recommended
• The individual questions are free of biased to an investor are suitable. . . . [A] reasonable
language. basis underlying suitability is due diligence
to assess an investor’s investment profile,
• Questionnaire scores have been correlated (with
which can be comprised of a risk-tolerance
a statistical correlation coefficient) to other
assessment, an investor’s age, other
measures of financial risk taking (e.g., participation
investments, financial needs, tax status,
in the stock market, portfolio holdings).
investment objectives, experience, time
• The scoring methodology and question weighting horizon, liquidity need, and other factors.
are clearly stated and free of objective factors
(e.g., time horizon, age, liquidity, risk capacity). The Investment Industry Regulatory Organization
These factors should be measured independently of Canada has a similar rule whereby a financial
within the broader risk profile, not “averaged” into advisor must be able to demonstrate that an
a single score measure. investor’s willingness and ability to take risks have
been measured and evaluated before an investment
Assuming a measurement tool exhibits elements recommendation is developed.29
of validity and reliability, the decision to use a risk-
tolerance questionnaire or revealed preference In the European Union, Article 25 of the Markets in
test should be driven by ease of use, the quality of Financial Instruments Directive II states,
documentation provided by the tool’s vendor, and When providing investment advice or portfolio
ongoing documentation of validity and reliability. management the investment firm shall obtain
The final risk-tolerance score—derived from either the necessary information regarding the
a questionnaire or a revealed preference test—can investor’s knowledge and experience in the
then be incorporated into the risk-profiling process investment field relevant to the specific type
as described in this report. of product, that person’s financial situation
including his ability to bear losses, and his
investment objectives including his risk
APPENDIX B tolerance.
In the United States, the Certified Financial Planner
Regulatory Background and Board of Standards, Inc., as an element of its Code of
Ethics and Standards of Conduct, also mandates the
Risk-Profiling Requirements measurement of risk-profiling factors for those who
Regulators and boards of professional practice in all hold the CFP® certification:30
major developed markets require advisory firms and A CFP® professional must act with the care,
financial advisors to assess and evaluate an investor’s skill, prudence, and diligence that a prudent
risk profile (or more precisely, the elements of an professional would exercise in light of the
IRP).27 Consider the FINRA customer due diligence Client’s goals, risk tolerance, objectives, and
requirements as prescribed in the United States. financial and personal circumstances. (p. 3)
Customer due diligence rules require financial advisors
to take steps to understand the nature and purpose of Similarly, the Association of International Certified
a customer relationship. FINRA rules further state that a Public Accountants mandates that those who hold
firm or financial advisor must28 the Personal Financial Specialist (PFS) designation,
as part of the Certified Public Accountant/PFS Body

27
See FINRA’s Customer Due Diligence Requirements for Financial Institutions (CDD Rule) and FINRA Rule 3310 (Anti-Money Laundering
Compliance Program).
28
Based on FINRA rules, investor financial risk profiles may consist of individualized risk scoring that allows an investor to be categorized into
an appropriate investment classification.
29
See Shawn Brayman, Michael Finke, Ellen Bessner, John Grable, Paul Griffin, and Rebecca Clement, Current Practices for Risk
Profiling in Canada and Review of Global Best Practices (Toronto: Investor Advisory Panel of the Ontario Securities Commission, 2015).
http://www.osc.gov.on.ca/documents/en/Investors/iap_20151112_risk-profiling-report.pdf.
30
Certified Financial Planner Board of Standards, Inc., Code of Ethics and Standards of Conduct (Washington, DC: Certified Financial
Planner Board of Standards, 2018). https://www.cfp.net/docs/default-source/for-cfp-pros---professional-standards-enforcement/
CFP-Board-Code-and-Standards.

18 | CFA Institute
Investment Risk Profiling

of Knowledge, assess elements of an investor’s goal achievement date. Generally related to age but not
risk profile,31 interchangeable.
reviewing client investment preferences Investing Experience: Related to financial knowledge
and risk tolerance to help them develop but can be gained only by “living through” various
appropriate investment strategies. (p. 8) economic cycles—in particular, severe economic
downturns. Contrary to knowledge, experience can
Globally, CFA Institute, in its Standards of Practice
be associated with high or low willingness to take
Handbook (11th edition), directs the following:32
financial risk, given that an investor’s past experiences
When Members and Candidates are in an naturally influence his perception of the riskiness of a
advisory relationship with a client, they possible future investment.
must . . . make a reasonable inquiry into a
Investment Risk Profile (IRP): The combination of
client’s or prospective client’s investment
factors about an investor that are expected to affect
experience, risk and return objectives,
the level of portfolio risk that would be appropriate
and financial constraints prior to making
for a financial advisor to recommend. Generally, an
any investment recommendation or taking
IRP will include all the factors listed in this appendix,
investment action and must reassess and
along with any other unique circumstances, tax/legal
update this information regularly. (p. 9)
considerations, biases, or personality traits.
Given the way existing rules have been written,
Market Risk Environment: The market interest rate,
nearly all “risk-profiling” tools in the marketplace can
inflation, and return expectations that exist at the
be used to meet regulatory customer due diligence
time of assessment.
requirements.33 In addition, nearly all existing tools
provide a basis for investor–advisor risk–return Need for Liquidity: An objective need or desire to
discussions. Financial advisors who are merely looking hold cash for ongoing current or future expected
for a regulatory compliance tool therefore have access distribution needs. High need for liquidity is often
to multiple alternatives. Additional assessment is related to a short time horizon.
required for those who wish to use the risk-profiling
Risk Capacity: Otherwise known as an investor’s ability
process described in this report.
to sustain portfolio volatility without material effect on
the investor’s standard of living or capability to meet
stated goals. High risk capacity is often related to the
APPENDIX C existence of an emergency fund, current outside and/
or employment income, access to credit, insurance
coverage, etc.
Risk-Profiling Terminology
Risk Composure: An individual’s past penchant
Consequence of Goal Failure: The subjective
for behaving in a consistent manner. An example
acceptability of failing to accomplish a financial goal.
assessment would be to enquire how an individual
Can be used as a scale whereby a high magnitude of
responded to the global financial crisis of 2008–2009:
unacceptability of failing to accomplish an investor’s
Did she or he sell, hold, or buy more?
goals would require higher relative weighting of the
investor’s risk-need factor and vice versa. Risk Need: The magnitude of risk necessary to
achieve a financial goal, based on predetermined
Financial Knowledge: An investor’s financial literacy
levels of expected return. The related required
concerning investing and risk–return dynamics.
RoR determination, calculated from present/future
Higher knowledge is generally associated with higher
value models, can be adjusted and reevaluated via
willingness to take investment risk.
manipulation of the input factors (present value,
Goal Time Horizon: Length of time, generally stated future value, number of payments, interest rate,
in years, between the present moment and the target payment).

31
Association of International Certified Professional Accountants, PFS Credential Handbook: A Guide to the AICPA Personal Financial Specialist
Credential (Durham, NC: Association of International Certified Professional Accountants, 2019). https://www.aicpa.org/content/dam/aicpa/
membership/join/downloadabledocuments/pfs-credential-handbook.pdf.
32
CFA Institute, Standards of Practice Handbook, 2014, 11th ed. (Charlottesville, VA: CFA Institute, 2014). https://www.cfainstitute.org/-/media/
documents/code/code-ethics-standards/standards-practice-handbook-11th-ed-eff-July-2014-corr-sept-2014.ashx.
33
Regulators have not historically prescribed validity, reliability, design, or interpretation guidelines related to risk-profiling tools, making nearly
all risk-tolerance and risk-profiling assessment tools compliant with regulations.

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Investment Risk Profiling

Risk Perception: An individual’s cognitive assessment • Doing so will trigger an automatic red light,
of the riskiness of a given situation, regardless of the indicating that the investor’s goal must
objective truth. Perception can be heavily influenced be reevaluated to realign with her risk-
by the media and an individual’s social environment, as taking ability.
well as a lack of thorough understanding of financial • A lower risk need is ignored when both risk-taking
concepts. ability and behavioral loss tolerance are higher.
Risk Preference: An individual’s general feeling or • Higher risk-taking ability is ignored when both the
partiality toward one or more options over another/ risk need and behavioral loss tolerance are lower.
others. Preference is a rank order of preferred choices. • Higher behavioral loss tolerance is ignored when
Although investors are assumed to be risk averse, both the risk need and risk-taking ability are lower.
some may have a greater preference for “return
• Low behavioral loss tolerance can never be
maximization” over “risk reduction.”
ignored; however, behavioral loss tolerance can
Risk Tolerance: The maximum level of uncertainty be used to “nudge” an investor into a higher-risk
an individual is willing to tolerate in exchange for portfolio when the risk need and risk-taking ability
incremental units of return. This term is often used are higher.
interchangeably in everyday nomenclature to mean • A financial advisor should not recommend a
“risk profile” or “risk attitude”; however, in practice, risk portfolio allocation that exceeds an investor’s risk-
tolerance is an individual’s willingness to implement taking ability.
a risky strategy after all other factors have been
• Risk-taking ability sets an upper volatility
considered.
bound to a portfolio recommendation.

Green Light Profiles

APPENDIX D Some IRP combinations represent
In the context of this report, a risk profile is the “green light” profiles, meaning that
combination of an investor’s risk need, risk-taking ability, no further calibration or data are
and behavioral loss tolerance. Given that each factor necessary to make an appropriate
may be characterized with three levels of intensity, portfolio allocation recommendation.
27 IRP combinations are possible.34 For example, an For example, if an investor’s IRP is HN,
investor with a very high IRP can be described as high HA, and HT, a financial advisor can
need (HN), high ability (HA), and high tolerance (HT). reasonably recommend a “high volatility portfolio,”
An investor with a very low IRP can be described as which for risk-profiling purposes is defined as a
low need (LN), low ability (LA), and low tolerance (LT). portfolio with at least 70% exposure to growth
However, rarely do all three factors align perfectly. assets (equities and alternatives). In the same way,
Essentially, each IRP can be thought of as representing a “moderate volatility portfolio” is one with 30% to
a different “risk personality.” An investor’s unique 70% exposure to growth assets, and a “low volatility
combination of IRP factors, as shown in Table D1, can portfolio” is one with less than 30% exposure to
be used by an investor, financial advisor, educator, growth assets.
or regulator when calibrating an investor’s IRP into
a portfolio asset allocation recommendation. This Yellow Light Profiles
calibration process is analogous to a traffic light that
“Yellow light” IRPs signal that an
instructs drivers to proceed on green, use caution on
investor’s behavioral loss tolerance is
yellow, and stop on red.
lower than either his risk need or risk-
The following risk-profiling rules apply when using the taking ability. This means the investor
IRP technique outlined in this report: may need some additional behavioral
interventions before investing in a
• An investor’s risk need cannot be higher than the
portfolio more consistent with his risk
investor’s risk-taking ability associated with the goal.
need and risk-taking ability.

Although 27 IRP combinations ultimately exist, only “green light” and “yellow light” IRP combinations, 18 in total, are acceptable when
34

making portfolio allocation recommendations.

20 | CFA Institute
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It may be appropriate for a financial advisor to “nudge” Red Light Profiles

an investor into a higher volatility portfolio in yellow light
cases. This behavioral “nudge,” or soft paternalism,35 When the required RoR (i.e., risk need)
may be necessary to promote what is objectively in and corresponding portfolio volatility
the best long-term interest of the investor; however, needed to accomplish an investor’s
this should not be automatically assumed. In practice, stated goal exceed an investor’s risk-
55% of investors understand that they need to take taking ability—whether this is because
investment risk to achieve their goals; however, 52% of of a short time horizon, liquidity
investors prefer to miss goal achievement rather than constraints, or a lack of risk capacity—
take additional investment risk.36 an automatic “red light” is triggered.

With this in mind, referencing the consequence of When the risk need exceeds risk-taking ability, an
failing to meet a stated goal is appropriate. If the investor and her financial advisor must reevaluate the
consequence is high, financial advisors should investor’s goals and expectations to bring them in line
recommend a portfolio consistent with the investor’s with the investor’s risk-taking ability, regardless of the
risk need and risk-taking ability. However, if the investor’s level of behavioral loss tolerance. A red-light
consequences of failure are low, financial advisors situation means that making a portfolio allocation
should initially recommend a portfolio consistent with recommendation will be possible only when the
the investor’s behavioral loss tolerance and attempt investor’s risk need and corresponding required RoR
to improve the investor’s financial knowledge and need are adjusted downward. For example, a financial
investing experience over time. advisor could recommend that an investor work longer,

TABLE D1.  HUBBLE–GRABLE THREE-FACTOR MODEL OF INVESTOR RISK PROFILING

Risk- Behavioral Green/
Risk Taking Loss Yellow/
Need Ability Tolerance Red Light Recommendation Strategy
High High High Green Proceed: Allocate All factors align; move forward with portfolio
Light to High Volatility implementation.
Portfolio
Mod High High Green Proceed: Allocate Moderate need can be safely ignored; move
Light to High Volatility forward with portfolio implementation.
Portfolio
Low High High Green Proceed: Allocate Low need can be safely ignored; move forward
Light to High Volatility with portfolio implementation.
Portfolio
Mod Mod Mod Green Proceed: Allocate All factors align; move forward with portfolio
Light to Moderate implementation.
Volatility Portfolio
Mod High Mod Green Proceed: Allocate High ability can be safely ignored; move forward
Light to Moderate with portfolio implementation.
Volatility Portfolio
Low Mod Mod Green Proceed: Allocate Low need can be safely ignored; move forward
Light to Moderate with portfolio implementation.
Volatility Portfolio

(Continued)

35
See Richard H. Thaler and Cass R. Sunstein, “Libertarian Paternalism,” American Economic Review 93, no. 3 (May 2003): 175–179.
36
See David Blake and Alistair Haig, How Do Savers Think About and Respond To Risk? Evidence from a Population Survey and Lessons for the
Investment Industry (London: The Pensions Institute, 2014).

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Investment Risk Profiling

TABLE D1.  HUBBLE–GRABLE THREE-FACTOR MODEL OF INVESTOR RISK PROFILING (CONTINUED)

Risk- Behavioral Green/
Risk Taking Loss Yellow/
Need Ability Tolerance Red Light Recommendation Strategy
Low High Mod Green Proceed: Allocate Both low need and high ability can be safely
Light to Moderate ignored in favor of moderate tolerance; move
Volatility Portfolio forward with portfolio implementation.
Low Low Low Green Proceed: Allocate All factors align; move forward with portfolio
Light to Low Volatility implementation.
Portfolio
Low High Low Green Proceed: Allocate High ability can be safely ignored; move forward
Light to Low Volatility with portfolio implementation.
Portfolio
Low Mod Low Green Proceed: Allocate Moderate ability can be safely ignored; move
Light to Low Volatility forward with portfolio implementation.
Portfolio
Mod Mod High Yellow Caution: Allocate Investor’s loss tolerance exceeds investor’s
Light to Moderate risk-taking ability; investor may expect or
Volatility Portfolio have a desire to take on more volatility than is
after Discussion prudent; some education may be required.
with Investor
Low Mod High Yellow Caution: Allocate Investor’s loss tolerance exceeds investor’s
Light to Moderate risk-taking ability; investor may expect or
Volatility Portfolio have a desire to take on more volatility than
after Discussion is prudent; some education may be required.
with Investor Low need can be safely ignored.
Low Low High Yellow Caution: Allocate Investor’s loss tolerance exceeds investor’s
Light to Low Volatility risk-taking ability; investor may expect or
Portfolio after have a desire to take on more volatility than is
Discussion with prudent; some education may be required.
Investor
Low Low Mod Yellow Caution: Allocate Investor’s loss tolerance exceeds investor’s
Light to Low Volatility risk-taking ability; investor may expect or
Portfolio after have a desire to take on more volatility than is
Discussion with prudent; some education may be required.
Investor
High High Mod Yellow Caution: Allocate Investor’s loss tolerance is lower than
Light Only after investor’s risk need and risk-taking ability;
Discussion with some education may be needed to encourage
Investor investor to increase volatility to meet goals;
do not assume investor is willing to increase
volatility exposure; reevaluating investor’s goal
to align with the behavioral loss tolerance score
may be necessary.

(Continued)

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TABLE D1.  HUBBLE–GRABLE THREE-FACTOR MODEL OF INVESTOR RISK PROFILING (CONTINUED)

Risk- Behavioral Green/
Risk Taking Loss Yellow/
Need Ability Tolerance Red Light Recommendation Strategy
High High Low Yellow Caution: Allocate Investor’s loss tolerance is lower than
Light Only after investor’s risk need and risk-taking ability;
Discussion with some education may be needed to encourage
Investor investor to increase volatility to meet goals;
do not assume investor is willing to increase
volatility exposure; reevaluating investor’s goal
to align with the behavioral loss tolerance score
may be necessary.
Mod High Low Yellow Caution: Allocate Investor’s loss tolerance is lower than
Light Only after investor’s risk need and risk-taking ability;
Discussion with some education may be needed to encourage
Investor investor to increase volatility to meet goals;
do not assume investor is willing to increase
volatility exposure; reevaluating investor’s goal
to align with the behavioral loss tolerance score
may be necessary.
Mod Mod Low Yellow Caution: Allocate Investor’s loss tolerance is lower than
Light Only after investor’s risk need and risk-taking ability;
Discussion with some education may be needed to encourage
Investor investor to increase volatility to meet goals;
do not assume investor is willing to increase
volatility exposure; reevaluating investor’s goal
to align with the behavioral loss tolerance score
may be necessary.
High Mod High Red Light Stop: Goal Reestablish investor expectations; investor’s
Achievement risk need exceeds investor’s risk-taking ability.
Problematic; Even though investor’s need and tolerance
Reevaluate Goals allow for a high volatility portfolio, investor has
only a moderate ability and can withstand only
a moderate volatility strategy.
High Mod Mod Red Light Stop: Goal Reestablish investor expectations; investor’s
Achievement risk need exceeds investor’s risk-taking ability.
Problematic; Investor has only a moderate ability and can
Reevaluate Goals withstand only a moderate volatility strategy.
High Mod Low Red Light Stop: Goal Reestablish investor expectations; investor’s
Achievement risk need exceeds investor’s risk-taking ability;
Problematic; some education may be needed to encourage
Reevaluate Goals investor to increase volatility to meet goal;
do not assume investor is willing to increase
volatility exposure; reevaluating investor’s goal
to align with the behavioral loss tolerance score
may be necessary instead. Investor has only
a moderate ability and can withstand only a
moderate volatility strategy.

(Continued)

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Investment Risk Profiling

TABLE D1.  HUBBLE–GRABLE THREE-FACTOR MODEL OF INVESTOR RISK PROFILING (CONTINUED)

Risk- Behavioral Green/
Risk Taking Loss Yellow/
Need Ability Tolerance Red Light Recommendation Strategy
High Low High Red Light Stop: Goal Reestablish investor expectations; investor’s
Achievement risk need exceeds investor’s risk-taking ability;
Problematic; some education may be needed to encourage
Reevaluate Goals investor to increase volatility to meet goal;
do not assume investor is willing to increase
volatility exposure; reevaluating investor’s
goal to align with the behavioral loss tolerance
score may be necessary instead. Investor has
a low ability and can withstand only a low
volatility strategy.
High Low Mod Red Light Stop: Goal Reestablish investor expectations; investor’s
Achievement risk need exceeds investor’s risk-taking ability;
Problematic; some education may be needed to encourage
Reevaluate Goals investor to increase volatility to meet goal;
do not assume investor is willing to increase
volatility exposure; reevaluating investor’s
goal to align with the behavioral loss tolerance
score may be necessary instead. Investor has
a low ability and can withstand only a low
volatility strategy.
High Low Low Red Light Stop: Goal Reestablish investor expectations; investor’s
Achievement risk need exceeds investor’s risk-taking ability.
Problematic; Investor has a low ability and can withstand
Reevaluate Goals only a low volatility strategy.
Mod Low High Red Light Stop: Goal Reestablish investor expectations; investor’s
Achievement risk need exceeds investor’s risk-taking ability,
Problematic; and investor’s loss tolerance exceeds investor’s
Reevaluate Goals risk-taking ability; investor may expect or
have a desire to take on more volatility than
is prudent; additional education is warranted.
Investor has a low ability and can withstand
only a low volatility strategy.
Mod Low Mod Red Light Stop: Goal Reestablish investor expectations; investor’s
Achievement risk need exceeds investor’s risk-taking ability,
Problematic; and investor’s loss tolerance exceeds investor’s
Reevaluate Goals risk-taking ability; investor may expect or
have a desire to take on more volatility than
is prudent; additional education is warranted.
Investor has a low ability and can withstand
only a low volatility strategy.
Mod Low Low Red Light Stop: Goal Reestablish investor expectations; investor’s
Achievement risk need exceeds investor’s risk-taking ability.
Problematic; Investor has a low ability and can withstand
Reevaluate Goals only a low volatility strategy.

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save more, spend less, or lower her future value target • As a couple, they have a moderate level of risk
to bring the risk need in line with risk-taking ability. tolerance (i.e., willingness to take risk).
Table D1 provides an overview of the different IRPs • They prefer investments that provide a mix of
that are possible using the categories of IRP illustrated safety and return (i.e., risk preference).
in this report. The strategies shown in Table D1 are • Based on discussions with Clint and Pat, you
intended to provide a financial advisor with guidance believe they have a moderate degree of financial
when interpreting IRP scores, as well as a foundation knowledge and some experience with investment
for further investor–financial advisor discussions. products (i.e., knowledge and experience).
• When you asked them to tell you “how risky the
markets are,” Clint and Pat answered that in their
CASE STUDIES opinion, the markets are not very risky (i.e., risk
perception).
The following case studies provide examples of how • You also know that during the last market
the three-factor model presented in this report can correction, they did nothing dramatic with their
be used in practice. The first case study illustrates a portfolio positions (i.e., risk composure).
capital accumulation scenario, and the second case Based on this information, estimating an IRP for Clint
illustrates a capital depletion/preservation scenario. and Pat that aligns with this particular goal is possible.
The following discussion highlights the steps in the IRP
Case One developmental process.
Clint and Pat Bronson have asked you to develop a Step 1: The process begins by estimating the net
plan to allocate current retirement assets and ongoing (after fees and taxes) required RoR necessary to
retirement savings. An important first step in the achieve the capital accumulation goal over the next
investment-planning process involves developing 11 years. Based on a simple time value of money
an IRP for Clint and Pat related to this capital calculation, Clint and Pat must generate an 8.23%
accumulation goal. During your initial meetings with annualized RoR to reach their retirement goal (the
Clint and Pat, you learned the following information: base return plus the advisory fee). At this point, you
must answer three questions using your capital
• Clint and Pat would like to accumulate $4,100,000
markets expectations:
for retirement.
• They have an 11-year time horizon. 1. Given the current market risk environment,
can the return need be realistically achieved:
• They currently have $1,200,000 saved for
yes or no?
retirement.
• You could choose yes, given historical stock
• Clint and Pat are aggressive savers; they are able
and bond returns.
to save $22,000 toward goal achievement each
quarter. 2. What is the level of portfolio volatility associated
• You charge a 1% assets under management fee. with the return need? The following guidelines
form the basis of the IRP model used in this case:
• All savings and investments are held in tax-
advantaged accounts. • Low: < 30% Growth Assets
• Moderate: 30% to 70% Growth Assets
Based on conversations with Clint and Pat, you
know that failing to meet the retirement goal is • High: > 70% Growth Assets
unacceptable. As such, Clint and Pat’s RISK NEED is HIGH; based on
In preparation for your next meeting with Clint and Pat, your models, a HIGH portfolio of at least 70% growth
you have gathered the following information about assets will accomplish the required RoR objective.
their situation: 3. What is the financial consequence associated
• Prior to retirement, Clint and Pat have sufficient with failing to meet the stated goal: acceptable,
outside income and other assets to maintain their unacceptable, or unknown?
standard of living in the case of an emergency. • You should indicate unacceptable, given the
• They have no significant liquidity needs at this case narrative.
time.

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Investment Risk Profiling

Step 2: The next step in the IRP development process 9 Investor has no significant liquidity needs
involves estimating the investor’s risk-taking ability. (> 5% of portfolio value) for at least 10 years.
The following guidelines should be followed:
9 Sufficient outside income and/or assets
are available to maintain standard of living
Test 1: If EITHER of the following situations is present,
(e.g., current income, access to credit, cash
the investor’s ability to take risk is LOW:
savings, insurance) in case of an emergency.
9 Time horizon is less than or equal to five years.
Otherwise, the investor’s ability is MODERATE.
9 The expected and/or ongoing annual liquidity
need is equal to or greater than 5% of the Answers to these questions suggest that Clint and Pat
portfolio value and no outside income or have a HIGH risk-taking ability score.
assets are available to maintain standard
of living (e.g., current income, access to Step 3: The third step in the IRP development process
credit, cash savings, insurance) in case focuses on estimating a behavioral loss tolerance
of an emergency. score. Each of the six inputs that comprise the
score comes from investor data-gathering forms,
Test 2: If ALL of the following scenarios are present, assessments, and notes made by you and/or your
the investor’s ability to take risk is HIGH: staff. Based on the inputs described in the case
9 Time horizon is greater than or equal to 10 years. narrative, Clint and Pat have a behavioral loss score
of 19, as shown below:

What is the investor’s risk tolerance or willingness to take financial risk? SCORE
Very Low Low Moderate High Very High 3
1 2 3 4 5
What is the investor’s preference when holding risky assets?
Maximize Mostly Mix of Safety and Mostly Maximize 3
Safety Safety Return Return Returns
1 2 3 4 5
How knowledgeable is the investor about financial and investment concepts?
Not at All Minimally Moderately Very 3
Knowledgeable Knowledgeable Knowledgeable Competent Knowledgeable
1 2 3 4 5
How much experience does the investor have with investment products?
None Very Little Some Modest Extensive 3
1 2 3 4 5
What is the investor’s perception of the riskiness of the stock market?
Very Risky Somewhat Risky Neutral Somewhat Safe Very Safe 4
1 2 3 4 5
In the past, when faced with investment losses, what action did the investor take?
Sold Out Did Nothing Purchased More 3
1 3 5

TOTAL 19

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Scores should then be matched to the following RoR Eric and Ariel need to earn in retirement to make
behavioral loss tolerance categories: their retirement dream a reality. You know the following
about their situation:
• LOW = 6, 7, 8, 9, 10, 11, 12, and 13
• MODERATE = 14, 15, 16, 17, 18, 19, 20, 21, and 22 • Eric and Ariel would like to plan for a 30-year
retirement period.
• HIGH = 23, 24, 25, 26, 27, 28, 29, and 30
• They have $11,000,000 saved in the royal treasury
Clint and Pat’s behavioral loss tolerance score is for retirement.
MODERATE.
• They would like to endow $2,000,000 to fund
Step 4: The fourth step in the IRP development process The Flounder Foundation, which is dedicated to
involves combining the risk need, risk-taking ability, mermaid conservation efforts, upon the death of
and behavioral loss tolerance scores. In the case of the second spouse.
Clint and Pat, • During retirement, the investors need a $350,000
• their risk need is HIGH; yearly income that will increase at the rate of
inflation (3%) yearly.
• their risk-taking ability is HIGH; and
• You charge a 1% assets under management fee.
• their behavioral loss tolerance is MODERATE.
• As sovereigns, Eric and Ariel are exempt from
This results in a score of HN, HA, MT. This score should taxation.
then be matched to Table D1 in Appendix D.
Based on conversations with Eric and Ariel, you know
Step 5: Once an IRP has been developed, the that failing to meet their retirement and bequest goals
next step involves evaluating the IRP score in is unacceptable.
relation to the investor’s risk need. For Clint and
Pat, the score results in a “yellow light” portfolio In preparation for your next meeting with Eric and Ariel,
recommendation. In other words, caution is warranted you have gathered the following information about
in implementing the portfolio recommendation. In this their situation:
case, although the risk need and risk-taking ability • When they officially retire, they will have no
scores match, they misalign with the behavioral loss outside income or assets available to maintain
tolerance score. their standard of living.
The “yellow light” outcome is a signal that you should • As a couple, they have a low level of risk tolerance
confirm with Clint and Pat the goal inputs and RoR (i.e., willingness to take risk).
requirements needed to achieve their goal. Clint • Eric and Ariel prefer investments that provide
and Pat need to (and likely should) take relatively safety over returns (i.e., risk preference); Ariel has
high portfolio risk to achieve their retirement goal; historically invested only in antique collectibles.
however, the behavioral loss tolerance score indicates
• Based on your professional experience, you
that during a market correction, Clint and Pat may
believe Eric and Ariel have a moderate degree
experience stress. As a result, Clint and Pat likely
of financial knowledge and very little experience
need ongoing education about market events and
with investment products (i.e., knowledge and
risks—focused on the benefits of diversification—to
experience).
encourage maintenance of the recommended portfolio.
Ongoing educational efforts to increase Clint and • When you asked them to tell you “how risky
Pat’s risk tolerance and financial knowledge should the markets are,” Eric and Ariel answered that
help to align market expectations, preferences, and in their opinion, the markets are very risky
perceptions with portfolio realities. (i.e., risk perception).
• You also know that during the last market
Case Two correction, Eric held his portfolio positions
even though other investors sold out
You recently started working with Prince (now King) (i.e., risk composure).
Eric and Princess (now Queen) Ariel. After many years
of ruling happily together, they are looking forward Based on this information, estimating an IRP for
to stepping aside and entering retirement. You have Eric and Ariel that aligns with their particular goal is
developed a retirement plan you believe will help them possible. The following discussion highlights the steps
step down from their royal duties and enter retirement. in the IRP developmental process.
A key element of your analysis involved estimating the

CFA Institute | 27
Investment Risk Profiling

Step 1: The process begins by estimating the net (after 9 Sufficient outside income and/or assets
fees and taxes) required RoR necessary to provide are available to maintain standard of living
income over the 30-year period, adjusted for inflation. (e.g., current income, access to credit, cash
In this example, a very simple income withdrawal savings, insurance) in case of an emergency.
strategy can be used to estimate a net real annual
return need of 5.10% (this includes a base return Otherwise, the investor’s ability is MODERATE.
estimate coupled with the inflation estimate and the
advisory fee). At this point, you must answer three As a reminder, Eric and Ariel have a time horizon of
questions using your capital markets expectations: 30 years. They need to generate $350,000 each year
(adjusted for inflation) from a $9,000,000 portfolio.
1. Given the current market risk environment, can the This is equivalent to a 3.18% ongoing liquidity need.
return need be realistically achieved: yes or no? Although the liquidity need falls below the 5%
a. You should choose yes, given historical stock benchmark, Eric and Ariel have limited outside income
and bond returns. and assets available to maintain their standard
2. What is the level of portfolio volatility associated of living, so they fail both tests. Therefore, their
with the return need? The following guidelines risk-taking ability score should be classified as
form the basis of the IRP model used in this case: MODERATE.
a. Low: < 30% Growth Assets Step 3: The third step in the IRP development process
b. Moderate: 30% to 70% Growth Assets focuses on estimating a behavioral loss tolerance
score. Each of the six inputs that comprise the
c. High: > 70% Growth Assets score comes from investor data-gathering forms,
Based on your market expectations, Eric and Ariel’s assessments, and notes made by you and/or your
RISK NEED should be categorized as MODERATE. staff. Based on the inputs described in the case
narrative, Eric and Ariel have a behavioral loss score
A MODERATE portfolio of 30% to 70% growth assets will of 13, as shown.
accomplish the required RoR objective.
Scores should then be matched to the following
3. What is the financial consequence associated behavioral loss tolerance categories:
with failing to meet the stated goal: acceptable,
unacceptable, or unknown? • LOW = 6, 7, 8, 9, 10, 11, 12, and 13
• You should indicate unacceptable, given what • MODERATE = 14, 15, 16, 17, 18, 19, 20, 21, and 22
is described in the case narrative. • HIGH = 23, 24, 25, 26, 27, 28, 29, and 30
Step 2: The next step in the IRP development process Their behavioral loss tolerance score is LOW.
involves estimating the investor’s risk-taking ability.
The following guidelines should be followed: Step 4: The fourth step in the IRP development process
involves combining the risk need, risk-taking ability,
Test 1: If EITHER of the following situations is present, and behavioral loss tolerance scores. In the case of
the investor’s ability to take risk is LOW: Eric and Ariel,
9 Time horizon is less than or equal to five years. • their risk need is MODERATE;
9 The expected and/or ongoing annual liquidity • their risk-taking ability is MODERATE; and
need is equal to or greater than 5% of the • their behavioral loss tolerance is LOW.
portfolio value and no outside income or assets
are available to maintain standard of living This results in a score of MN, MA, LT. This score should
(e.g., current income, access to credit, cash then be matched to Table D1 in Appendix D.
savings, insurance) in case of an emergency. Step 5: Once an IRP has been developed, the next
Test 2: If ALL of the following scenarios are present, step involves evaluating the IRP score in relation to
the investor’s ability to take risk is HIGH: the investor’s risk need. For Eric and Ariel, the score
results in a “yellow light” portfolio recommendation,
9 Time horizon is greater than or equal to 10 years.
meaning that caution is warranted in implementing
9 Investor has no expected and/or ongoing annual the portfolio recommendation. Why?
liquidity needs that are greater than 5% of the
portfolio value.

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Investment Risk Profiling

What is the investor’s risk tolerance or willingness to take financial risk? SCORE
Very Low Low Moderate High Very High 2
1 2 3 4 5
What is the investor’s preference when holding risky assets?
Maximize Mostly Mix of Safety and Mostly Maximize 2
Safety Safety Return Return Returns
1 2 3 4 5
How knowledgeable is the investor about financial and investment concepts?
Not at All Minimally Moderately Very 3
Knowledgeable Knowledgeable Knowledgeable Competent Knowledgeable
1 2 3 4 5
How much experience does the investor have with investment products?
None Very Little Some Modest Extensive 2
1 2 3 4 5
What is the investor’s perception of the riskiness of the stock market?
Very Risky Somewhat Risky Neutral Somewhat Safe Very Safe 1
1 2 3 4 5
In the past, when faced with investment losses, what action did the investor take?
Sold Out Did Nothing Purchased More 3
1 3 5

TOTAL 13

• The behavioral loss tolerance score for Eric and In situations where the consequence of goal failure
Ariel as a couple is not consistent with their risk is acceptable—for example, a determination is made
need and risk-taking ability scores. that leaving the bequest is not that important in
relation to achieving the larger retirement goal or that
Because of the “yellow light” outcome, Eric and
spending can be decreased—no compelling reason (or
Ariel, under your direction, should circle back to the
need) may exist to encourage the investors to accept
“consequence of goal failure” question. Based on the
volatility that exceeds their stated behavioral loss
case narrative, you know that Eric and Ariel feel that
tolerance.
failure to meet their goal is unacceptable. Given this
fact and the “yellow light” outcome, an appropriate When the consequence of failure is unknown, further
approach would be to discuss implementing a discussion may be warranted and different scenarios
moderate portfolio allocation (a portfolio consistent presented as options. The investor should rarely,
with their risk need and risk-taking ability scores), however, be encouraged to invest in a high volatility
coupled with educational efforts to increase Eric and portfolio when the investor’s behavioral loss tolerance
Ariel’s risk tolerance and financial knowledge, as well is low.
as to realign their market expectations, preferences,
and perceptions.

CFA Institute | 29
Investment Risk Profiling

AUTHORS
Amy Hubble, CFA
Radix Financial, LLC

John E. Grable
University of Georgia

Robert W. Dannhauser, CFA

CFA Institute

CONTRIBUTORS
Gayle Buff, CFA
Brian Galley, CFA
Thomas Trainor, CFA

30 | CFA Institute
ISBN 978-1-942713-92-0

9 781942 713920

www.cfainstitute.org
[email protected]