John A. Lutjemeier, Ed.D.
If you agree that it is the time money is invested and not the timing of an investment that makes the money for investors, then you will also understand the importance of an investor’s ability to cope with market volatility or risk. Through out its long and colorful history, the financial service industry has invested a significant amount of its own financial resources in the development of products and investment advice in an attempt to manage risk; however, it has not developed a means to quantify their client’s internal ability to cope with the risk. It has been stated that one of the most important jobs of a financial advisor is to “hold the investor’s hand” when the market is in a normal trading range and to” grab the investor’s ankles” when the market plummets. If the internet replaces the broker, the need for quantifying the ability of investors to cope and understand their feeling about risk will increase. In The Lexus and the Olive Tree Thomas L. Friedman, the Pulitzer Prize-winning foreign affairs columnist for the New York Times who specializes in globalizationdiscusses how the Internet and telecommunications technology has given every investor sophisticated financial data that heretofore was available only to brokerage houses.
Not only can investors now buy and sell stocks and bonds from all over the world, not
only can they now do that buying and selling from their home computers, but Internet
brokerage sites are now giving them – for free – the information and analytical tools
to make those trades without having to call a broker. (Friedman)
Internet sites and communication technology cannot help a client understand his risk tolerance for any investment.
The financial planner’s responsibility includes finding the best match between the client’s ability to tolerate risk and the risk in the array of investments. Fear and greed can be wild cards as a client can prefer a higher level of risk during normal or favorable conditions and a lower one in stress conditions.
This presents a problem for the planner: what causes stress can be different for each investor. When the market is going up, it is easy for a client to say “I have a high risk tolerance, buy it.” When the market is going down, the client may feel “I have a low risk tolerance, I can’t take this risk any longer, sell it.”
In the February, 2003 issue of Research FPA then-President-Elect Elizabeth Jetton states her belief that the best planning comes from understanding the whole client – the client’s deepest values. She says, “We spend a great deal of time getting to know what the client cares deeply about – things that may not seem directly money-related on the surface, but truly are.” (Rusoff)
She is “trying to protect clients from themselves – from being their own worst enemy. (They’re) emotional in the market at the worst possible times and (their) instincts don’t pay very well when it comes to making financial decisions.” (Rusoff)
The financial service industry quantifies the risk inherent in the panorama of financial investment choices. Economic indicators, presidential elections, Middle Eastern conflicts, interest rates, the price of oil, etc., all affect risk in investments; these factors tend to act independently of each other.
The financial service industry does not quantify risk tolerance inherent in the investor. Instead a financial advisor asks a client questions; different advisors ask different questions. Even when investors understand and answer the questions, their answers today might be very different from their answers even six months from now.
What is needed is a scientific test of assessing the psychological risk tolerance profile inherent in the client. A scientific test offers stability throughout the sometimes wide-ranging changes mentioned above in the investment market. Such a test should be based upon psychological constructs because psychological constructs, such as coping strengths, remain relatively stable throughout life. Further, this test must provide a client risk tolerance profile in normal conditions as well as in stress conditions.
Such a scientific test quantifies risk tolerance within the investor. With investor risk tolerance quantified and investment risk tolerance quantified, the financial planner can do a better job of matching the investment and the client.
The SORT Test© assesses risk tolerance based on a client’s psychological construct (coping strengths) in normal and in stress conditions. Since it gives both, the client can average these two to get his Average Score. An investor who wants to select investments based on a consideration of market fluctuations in normal and in stress conditions can, therefore, figure his Average Score and invest these percentages in each of the four risk tolerances. This test is the only scientific test on the web based on a psychological construct (coping strengths) that assesses client risk tolerances and yields scores in normal and in stress conditions.
What is the SORT Test©?
SORT stands for Scientific Ordering of Risk Tolerance. The test is scientific since it was built and has been revised over time using identifying traits of the four coping strengths. “Ordering of risk tolerance” refers to the fact that each coping strength requires (orders) one kind of risk tolerance.
The SORT Test© calculates risk tolerance to a variety of life experiences in both normal and stress conditions. It was created in 1977 to assess employee risk tolerance in corporate change management consulting and revised in 1990 to use in the private practice of psychology.
In 2003 it was again revised to use in the financial industry to assess client risk tolerance. Financial planners, estate planners, bankers, and other professionals now have a tested methodology for identifying and assessing the traits of these four coping strengths and risk tolerances (CARTs).
The test has 40 questions and takes about 16 minutes to complete. 20 of the questions describe Normal Conditions, and 20 describe Stress Conditions. On each question there are two choices. The instructions ask the test person to divide 0- points between the four choices. The Test Report gives three scores: Normal Conditions, Stress Conditions, and Average Score.
There are two forms of the SORT Test© (1) for CFPs and Investors and (2) for Individuals. The financial planner takes the test thinking of himself as he is working with a client. The client takes it thinking of himself as an investor. The SORT Test© paves the way for the investor and financial planner to have the same understanding of their individual and shared risk tolerances to plan strategies for financial success. An individual can use this test for self help strategies in personal goals. He selects one role in his life – professional, significant other, parent, grandparent, etc. – and takes the Individual SORT Test©.
Coping Strengths and Risk Tolerances (CARTs)
| Coping Strength | Risk Tolerance | Viewpoint |
|---|---|---|
| Achiever | High Risk | “I have to take higher risks to get higher returns and I will do that.” |
| Developer | Medium risk | “I want the best. I am willing to take medium risk to get quality.” |
| Controller | Low Risk | “I play it safe. I select investments that are low risk and preserve capital.” |
| Facilitator | Balanced Risk | “I want everyone to be happy with our investment decisions. I am happy when others are happy.” |
Coping Strengths and Risk Tolerances (CARTs)
Each coping strength requires a different kind of risk tolerance. The Dominant CART is the one with the most points. The other three are ranked two, three and four. The results are expressed in percentages. For example, results may indicate 25% Achiever (High Risk), 30% Developer (Medium Risk), 35% Controller (Low Risk) and 10% Facilitator (Balanced Risk. The test gives percentage points for the four risk tolerances for the three scores: Normal CART, Stress CART and Average CART. The percentages on these four risk tolerances make a CART Profile. This example is a CART Profile.
Is taking the SORT Test the only way to understand a client’s risk tolerance?
No, this article tells four methods for recognizing when a client is making decisions under the influence of each of the four Dominant CARTS: (1) a case study, (2) success strategies, (3) success stories and (4) investment mistakes due to the excessive use of each CART.
What contribution can this test make to financial planning?
When the client and the financial planner consider his risk tolerance profile together based on a scientific test that quantifies client risk tolerances along with the usual questions the client answers, they can structure an investment portfolio that fits his risk tolerance in stress conditions and in normal ones. If the client’s investment portfolio later becomes too risky for his client’s risk tolerance profile (CART Profile), the professional can recommend portfolio revisions.
To guard against the difficulties experienced during the 2000 – 2003 market downturns, a financial advisor can suggest that the client invest the percentages in his Average CART Profile. Married clients can figure their Couple’s Average CART Profile and invest these percentages. The client(s) and the financial advisor can sign and date the agreement to do this. This agreement can be a record of what percentages the client invests in each CART on this date.
Test Validity and Reliability
In the Journal of Financial Planning article “Insights from Psychology and Psychometrics on Measuring Risk Tolerance” (Rozkowsky) Bouchey addresses the reliability of client questionnaires.
One way to improve the reliability of a risk tolerance questionnaire might be to
introduce more science into the process and enlist the help of psychologists or
sociologists. These professionals have been trying to elicit answers from people for
a long time and understand how to quantify them in ways that are more statistically
valid than a random set of questions like those most planners use.
To be credible a test of risk tolerance must have validity and reliability. To assess validity and reliability, 118 investors who are either business owners or MBA students at Houston Baptist University took this test.
The SORT Test© has both validity and reliability. A valid test measures what it claims to measure. In the test construction, the four sub-traits under each CART are appropriate measures of risk tolerance. Additionally, the questions are constructed so that each CART competes fairly with each other CART to be selected.
A reliable test has consistent results when the same person takes the test more than once. When a psychological test has been given to thousands of subjects over a period of many years we expect a test-retest reliability coefficient of .80 or above. However, this is the first time that the SORT™ Test has been given to a group of investors. Without a base of at least a thousand investors its reliability of .75 is an acceptable one. The website for the SORT allows investors and financial planners to add to the database which would present the option of additional assessment.
1. CART Actions in a Client Case Study
A case study is a good way to see Dominant CART actual behavior. Listen to what your clients say about what they do at work. Here Al illustrates the Achiever Dominant CART; you see the behavior of the other three in CART Success Strategies.
“Al, the Achiever Dominant CART”
Al, Sr. founded Profit Properties, a family business. He is 70, 100 lbs. overweight, and has had two heart attacks. He has no will, no trust, no corporation, and no business succession plan. His wife Faye and children Carl and Donna are afraid to approach him about plans for the future.
Al built Profit Properties from nothing. He has 50 years in this business and plans to run it for at least 15 more years. He likes the challenge and the chance to amass a substantial amount of money.
When you ask Al what he enjoys most about his work, he tells you how exciting it is to turn a disadvantage into an advantage. He buys a rundown property in a good neighborhood. He does whatever it takes to increase its value and sells it at the top of the market. The profit motivates him to select other similar properties and repeat the process. The combination of challenge and profit is invigorating. He rewards his success with food.
After the second heart attack Al slowed down, lost 30 pounds, was not having any fun, and fought depression. By the fourth month he was back to the same pace he had maintained for 49 years.
Taking high risk charges his adrenalin. The doctor says that if Al stays on an adrenalin high, he is at risk for having a third heart attack at any time. He is also is a diabetic and has high blood pressure.
2. CART Success Strategies
Asking, “How did you get to be so successful?” can allow clients to reveal their Dominant CART. Here each family member reveals one CART’s success strategies.
Al, the Achiever Dominant CART: Al tells you that early in his career he learned that he had to take risks if he wanted to get ahead. You ask him what kinds of risks make the most money. You ask for examples. Then you listen as he tells you more about how he became successful.
Faye, the Facilitator Dominant CART: Faye, Al’s wife, tells you that she taught the kids how to work together as a team and make work seem like play. Donna learned from her mother how to manage her work crews. Faye wants to get all of the family back in the business, including Al Jr. who left to start this kind of real estate firm in another state. You listen as she tells you how she plans to accomplish this goal. You compliment her on how she cares for each person.
Carl, the Controller Dominant CART: Carl tells you that he is the son who runs this business in a cost effective manner. He says that it makes good sense for a property purchase to fit the Long Range Plan. He keeps remodeling costs down and maintains records on properties to learn which properties are likely to turn a good profit. You ask him what he wants to do in the next five years.
Donna, the Developer Dominant CART: Donna tells you that the secret of her success is that she insists on quality. She assesses a property to be sure that it will still be valuable years from now. She trains her work crew so that they can do their best. Her work crew sends their children to work for her, too. She discovers and develops their talents. You ask what her next focus area is for improving the value of a property. Then you ask what else she plans to develop her employees.
3. CART Success Stories
Listening closely to your client’s success stories is a third way to learn his Dominant CART. The more you ask, “What do my client’s words reveal about his Dominant CART?” the better you will become at recognizing it. The more clients you do this process with the faster you will learn.
An ability to make accurate predictions about a client’s Dominant CART may have value in structuring an investment presentation. He will still make decisions based on its merits; your consideration of his Dominant CART may place your recommendation in its most favorable light.
4. Client Investment Mistakes Due to the Excessive Use of a CART
Fourth, your client can show the excessive use of a CART by making investment mistakes. When your client takes these actions, he gives a clue as to which Dominant CART characterizes him.
| CART | Example of a Cart | Excess which can cause an investment mistake |
|---|---|---|
| Achiever (High Risk) | I take a step immediately when action means success. | I see a new investment–I want to buy it fast. I may buy before I see all of the risks and sustain a substantial loss. |
| Developer (Medium Risk) | I select only the highest quality investment. This one is not yet perfect enough for me to select. | I resist diversifying into companies that meet only 95% of my criteria for quality; if the other 5% is time-weighted I will not invest without these results. I might miss out on some growth. |
| Controller (Low Risk) | I thoroughly research all options. | I may go into Analysis Paralysis studying 39 options. I may become so confused that I cannot decide. |
| Facilitator (Balanced Risk) | I adjust to what others want. | I might forget to select investments to fund my goals as I fund other’s goals. |
Summary
A financial planner knows how to quantify risk tolerance inherent in the panorama of investments. The SORT Test© facilitates quantifying risk tolerance within the investor, meeting acceptable psychometric standards for validity and reliability. With investment risk tolerance quantified and investor risk tolerance quantified, professionals can do a better job of matching the investment and the client.
This article gives five methods for discovering a client’s Dominant CART. First, a statement of each Dominant CART’s traits tells what behavior we are seeking. Second, a case study with one Dominant CART illustrates a business role. Third, each Dominant CART’s success strategy reveals what he values strongly enough to put into action. Fourth, a client’s success stories add insight. Fifth, client’s investment mistakes target his Dominant CART.
To guard against the difficulties experienced during the 2000 – 2003 market downturn, a financial advisor can suggest that the client invest the percentages in his Average CART Profile. Married clients can figure their Couple’s Average CART Profile and invest these percentages. The client(s) and the financial advisor can sign and date the agreement to do this. This agreement can be a record of what percentages the client invests in each CART on this date.
About listening, FPA Past President-Elect Jetton says, “Actors must learn it. Journalists must perfect it. Financial planners must cultivate it.” (Rusoff) Listening to your client can tell you his Dominant CART – his risk tolerance. Understanding a client’s Dominant CART might be a better barometer of client risk tolerance than greed and fear.