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Investor Profile Questionnaire

Key Points

  • Before making any investing decisions on your behalf, your advisor seeks to understand your investment profile, including individual circumstances and tolerance for risk.
  • Traditional measures of risk tolerance have some limitations.
  • With an expanded scope, the Investor Profile Questionnaire (IPQ) is designed to be a more effective gauge of your overall risk tolerance than traditional risk tolerance questionnaires.

Introduction

Proper asset allocation can improve the likelihood of meeting your investment goals. Through Institutional Intelligent Portfolios™, advisors offer a range of portfolios to address their clients' various goals, financial situations, constraints, and preferences. The Investor Profile Questionnaire (IPQ) helps your advisor determine whether your recommended portfolio is consistent with your stated goals, time horizon, and risk profile.

The IPQ and related questions for the account opening process were developed based on rigorous research, considering both objective (factual) and subjective (behavioral) information provided. This whitepaper describes the methodology behind the IPQ and how responses are used to calculate risk scores and help advisors identify the appropriate portfolios for their clients.

Investor Profile Questionnaire

The goal of the IPQ is to help an advisor understand a client's comprehensive profile. Traditional questionnaires generally focus only on risk tolerance, a method that may yield limited benefits because it ignores behavioral issues, among other factors.1 

The IPQ expands the scope of the traditional questionnaire by seeking insights into an investor's ability, or capacity, to take risks as well as their willingness to take risks. The capacity to take risks is dependent on an investor's financial situation (income, wealth, etc.), while an investor's willingness to take risks is based on behavioral factors.

The IPQ also includes, when applicable, questions that are designed to capture a preference for Total Return or Income focused portfolios and the tax status of the account.

Risk Capacity

Risk capacity is based on information about an investor's financial situation. That information can generally be obtained by asking specific objective questions about their length of time to retirement and investment goals.

Risk Willingness

Risk willingness is typically indicated by the level of volatility an investor is comfortable with and other factors. Details about risk willingness can be obtained by asking questions related to behavioral tendencies, such as the action that may be taken after experiencing a significant investment loss.

Risk capacity and risk willingness are generally independent of each other.

Design of Questions

The series of IPQ questions was finalized based on the following design criteria:

  1. Ensure that enough information is collected to identify a target asset allocation for each investor.
  2. Limit the number of questions to keep the user interaction as simple and brief as possible.
  3. Use simple and straightforward questions. This allows investors to provide valid and clear responses without assistance from a professional.
  4. Avoid answer sets that lead to no choice. Available responses for each question should cover all possible choices that investors could make.
  5. Personalize questions to improve the validity and consistency of investors' responses. There are two specific effects of this feature:
    • Conditional (or customized) Questions: Based on responses to earlier questions, the IPQ determines that some questions may not be relevant and, in such cases, those questions are not asked. For example, investors in taxable accounts may have the option of enrolling in tax-loss harvesting, but investors opening retirement accounts will not see this question as it is not relevant for their retirement accounts.
    • Personalized Responses: Based on the responses gathered up to a certain point, responses to later questions are customized. For example, instead of displaying a range of possible investment returns in % terms, the IPQ uses the initial investment input provided by investors and then converts it to an amount-based range. This helps address a widely documented cognitive bias that investors can better relate to returns expressed in amounts than in percent terms.
  6. Request a different portfolio—within predefined bounds. This request goes to your advisor to review and either approve or change it.
  7. Ensure responses are consistent throughout the questionnaire. A number of business rules have been designed to validate responses and alert users of any inconsistencies.

Validating Responses

Research shows that it is essential for responses provided by investors to be consistent. Answering questions inconsistently or even answering one question incorrectly could have a significant impact on which portfolio an advisor may recommend2.  If inconsistencies are observed, investors could be contacted by their advisor to discuss their answers in more detail and potentially recommend a change.

Risk Scoring

The IPQ establishes two separate risk scores to help an advisor identify the most appropriate portfolio for an investor: Risk Capacity Score and Risk Willingness Score. The scores are calculated by assigning different weights to individual responses to questions.

The IPQ contains up to 14 questions:

  • Five questions capture factual information to assess investors' risk capacity.
  • Five questions collect information about investors' behavioral attitude toward risk. The responses help calculate an investor's risk willingness score.
  • A question about the investor's age is always asked, and three questions may be asked about product preferences, such as Total Return/Income or Muni/Taxable bonds, depending on whether those portfolio features are offered. The responses aren't factored into the risk score, but they help determine the proposed portfolio.

Risk Scoring Methodology

When an investor answers a question, their choice will be assigned a numerical value.  For answers that imply a higher level of risk willingness or capacity, a higher score will be assigned. For answers that imply a lower level of risk willingness or capacity, a lower score will be assigned.

The maximum Risk Capacity Score and Risk Willingness Score is 100 points each. Both scores are assigned equal weighting in the final calculation to determine the advisor's recommended portfolio for the investor.

Risk capacity-related questions are important because they are entirely objective and provide meaningful scientific input. Historically, when designing a personal portfolio, financial advisors would often focus solely on risk capacity-related questions to determine the appropriate level of risk an investor could tolerate.

Findings from a study titled "Insights From Psychology and Psychometrics on Measuring Risk Tolerance"3 indicate that combining risk-attitude-related (or behavior-related) questions with objective questions will provide a more complete understanding of the investor.

By including risk-willingness-related questions, the portfolio that the advisor ultimately recommends to each investor can more closely capture the level of risk they are most comfortable with. The reason for this, simply put, is that humans are not machines. Investors have feelings and emotions that will undoubtedly impact their investment style. By addressing this early on and incorporating these subjective views into their risk score, investors may be more likely to stay invested.

Conclusion

The IPQ has been designed to include an understanding of both an investor's financial situation and their attitude toward risk. The IPQ assigns different weights to responses to a series of questions as part of the process of calculating a Risk Capacity Score and Risk Willingness Score.

The two scores are then used to identify an advisor-recommended portfolio. It is important to note that some questions (such as age) are not scored because they are, by themselves, not considered to have significant impact on risk capacity or risk willingness. More specific information, such as an investor's investment goals or the time horizon, is instead used in the risk scoring calculations. Information about total liquid wealth or income is not included because the IPQ is goal-specific.

1. Michael Pompian, "Behavioral Finance and Investor Types," CFA Institute, Private Wealth Management, 2012.

2. Paul Bouchey, "Questionnaire Quest: New Research Shows That Standard Questionnaires Designed to Reveal Investors' Risk Tolerance Levels Are Often Flawed or Misleading," Financial Planning, July 2004.

3. Roszkowski, Davey, and Grable, 2005.

Important disclosures:

Investing involves risk, including loss of principal. The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

See important disclosures below.

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