Measuring the gap between elicited and revealed risk for investors: An empirical study

Financial advisors use questionnaires and discussions with clients to determine investment goals, elicit risk preference and tolerance and establish a suitable portfolio allocation for different risk categories. Financial institutions assign risk ratings to their financial products. Advisors use these ratings to categorize products into the same risk categories used for portfolio allocation. Subsequently, clients select a portfolio of assets whose risk profile we call revealed risk. This paper proposes a novel methodology for comparing an individual's elicited and revealed risk. We propose using Value-at-Risk to measure elicited and revealed risk and the discrepancy between them, showing whether clients are over-risked or under-risked. We demonstrate the methodology using a dataset from a Canadian private financial dealer. We find that elicited risk is consistently higher than revealed risk–advisors build a safety buffer into their recommendations–and elicited risk varies with respect to demographic features and trading behaviors in expected ways–investors are receiving sound advice. This risk discrepancy could be used, for example, to gauge the quality of financial advice an individual is receiving, or it could be used to help advisors communicate inconsistencies between client trading actions and client goals. Our methodology falls into the interest realms of advisors, regulators, and dealerships.