The market crash of the past 10 months would give anyone pause to question the utility of standard client risk profile questionnaires. For example, how is it that clients seem to have a high risk tolerance during bull markets and a low risk tolerance during bear markets? Certainly many clients seemed to have changed their risk tolerances recently.

How can you get a more accurate picture of a client's risk tolerance? It helps to understand the three primary components of a client's risk profile: risk tolerance, risk capacity and perceived risk.

Risk tolerance is a psychological trait like intelligence, personality or aptitude. It measures how an individual feels about taking risk.

For example, have you ever been a passenger in a car when the driver seems to be going either very fast or very slow? The speed obviously feels right to the driver, but you're uncomfortable. Either you're anxious that there will be an accident or you're wondering why the driver is just creeping along. Many factors determine a person's driving behavior, but a key element is the person's tolerance for risk. The fast driver has a higher risk tolerance than you do, the worried passenger and the slow driver's risk tolerance is lower than yours.

Risk capacity is a financial consideration, i.e., how much risk the client can afford to take. Can the individual's financial situation withstand the impact of a negative outcome? Imagine that your 75-year-old mother decides to go skateboarding. You try to talk her out of it because while she may have the appropriate risk tolerance for it-after all, she wants to do it-she doesn't have the appropriate risk capacity: a fall at her age could lead to a broken hip or some other incapacitating injury.

So you give the skateboard to your eight-year-old son instead. He doesn't want to try it because his friends have had accidents and he doesn't want to get hurt. This is the opposite situation: He has the risk capacity because his reaction time and coordination are as strong as his young bones and he will recover quickly from any injury. But he doesn't have the tolerance, the psychological inclination to take this type of risk.

Advisors are readily able to evaluate risk capacity by analyzing a client's financial circumstances, such things as time horizon, goals and existing assets.

Perceived risk is what you don't know might hurt you. Many people who bought sub-prime investments with AAA ratings didn't realize they were taking a big risk. We now know that the ratings of those investments were problematic, but investors put their faith in the AAA rating and failed to perceive the actual risk involved. Perceived risk explains why your clients seem to be more risk tolerant in a bull market and less so in a bear market. In fact, it isn't their risk tolerance that changes, but their perception of risk. In a bull market, investing in stocks doesn't seem so risky; in a bear market, it does.

Risk tolerance, capacity and perception all come into play when advisors do planning with clients. All are important, but they should be addressed separately. Instead, current questionnaires confuse them. For instance, an answer choice on a questionnaire such as "I make withdrawals from my investments to cover my living expenses" or "I do not plan to make withdrawals from this investment over the next several years" address risk capacity and are not valid for assessing risk tolerance. Questions that require explanation are also problematic because the advisors are likely to introduce bias with their explanations. Then there are wealthy clients who can afford to take a lot of risk but who don't want to. It's important that advisors recognize these distinctions. Current risk questionnaires that conflate these three aspects of a risk profile make scoring the results and hence the outcomes flawed. This includes standard-issue questionnaires, which are commonly used to select a model portfolio for the client.

A better way to measure a client's attitude toward risk is a psychometric profile. Psychometrics is the branch of psychology that deals with designing and interpreting quantitative tests that measure variables such as intelligence, aptitude and personality traits. It's widely used in educational assessments of people's reading, writing and math abilities, and in assessments of people's aptitudes.

Psychometrics is based on a series of testing and re-testing, comparing results to see if the questions are accurately assessing the test-taker's risk-taking behavior compared with a sample of test- takers. These questionnaires are designed to be clear, in plain English, to be valid, that is, to actually measure what they set out to measure (i.e., risk tolerance versus risk capacity or financial knowledge). The results of psychometric tests should be reliable, or they should actually show a high score repeatedly for people with high risk tolerance, for example. That shouldn't change whether the client takes the test today or a month from today.