Why Risk Tolerance Questionnaires Don’t Work

Why Risk Tolerance Questionnaires Don’t Work

We once had a client who insisted on having a portfolio of 100% stocks. We advised him against this decision. He was able to achieve his financial goals with a globally diversified portfolio that balanced stocks and bonds, so there was no need for him to take on the additional risk of holding only stocks. But he insisted the additional risk wasn’t a problem. It was early 2007, and the stock market was very strong. A few months later the financial crisis of 2007- 2008 began. He called in a panic: “I can’t stand it! Can you get me out of the market today?”

People overstate their ability to handle risk. They think they can stomach market downturns better than they actually can. Overstating risk tolerance is a specific example of a general human problem: people in general—you and I included—are often wrong when it comes to assessing our own abilities.

So, it’s surprising that many wealth managers try to match investors with portfolios using questionnaires that ask people to assess their ability to handle risk. The crux of those questionnaires asks people to assess how they would respond to market declines. But unless investors have lived through previous market declines, they are usually very bad at assessing how they would respond. Moreover, they don’t consider how they would respond to a short-term decline lasting a few weeks versus a decline lasting a several months or even years.

Another problem with risk questionnaires is that they typically don’t ask people about their specific financial goals. But knowing those goals is essential to assessing the amount of risk that’s appropriate for your situation. Ideally, you need to calibrate the level of risk in your portfolio to meet your financial goals. For example, a young couple trying to accumulate financial assets for the future needs to treat risk differently from a person in retirement. The young couple is continuing to earn income and can afford some short-term declines in order to achieve larger long-term gains. They should thus take on a greater amount of risk in their investment portfolio than a retiree who’s no longer earning income. The retiree, by contrast, needs to focus on protecting the purchasing power of the money they have. As a result, they should take on less risk in their portfolio and focus on offsetting living cost increases with their investments.

A final problem with these questionnaires is that the kinds of answers people provide depend on their state of mind at the time. If the markets are up on Tuesday when they’re answering risk-assessment questions, they’re more likely to overestimate their risk tolerance than if the markets are down on that day. As a result, risk-tolerance questionnaires often provide nothing more than a snapshot of how people feel about risk on a given day; they don’t reveal people’s general attitude toward risk over the long term.

Some wealth managers sidestep the problem with self-assessment questionnaires by offering only one kind of portfolio: you are either totally in the market or totally out. There is no attempt to balance the portfolio with different stock and bond portfolio allocations. The problem with this one-size-fits-all approach is that it ignores your specific circumstances and investing time horizon.

Your particular financial situation is unique. An investment portfolio that might be suitable for your friends or neighbors might not be suitable for you. Your goals and financial circumstances, as well as your background and personality, likely differ from theirs. As a result, you need to tailor your investment strategy to fit your circumstances. Yet this one-size-fits-all approach makes tailoring impossible. The result is that people end up trying to predict optimal times to invest or divest. But this approach is problematic for a simple reason: you can’t predict the future. That’s why crystal balls don’t work. It’s why people lose at poker and roulette. It’s also why no one can predict the optimal time to enter or exit the stock market.

The alternative to both of the approaches I’ve described is to have a financial advisor who tailors your portfolio to fit your overall long-term goals. It’s these goals that should set your risk profile, not an error-prone self-assessment, and not a one-size-fits-all portfolio that ignores the specifics of your situation. A real financial advisor aims at building a portfolio that takes on enough risk to achieve those goals—no more, no less.

One way to consider investment risk is to view it the same way you view the speed of your car. If your desired destination is 2 hours away, but you need to be there in less than 2 hours, you need to drive faster to get there on time. Just realize that when you drive faster you take on additional risk, such as the risk of a speeding ticket or wreck. Conversely, if you can travel the distance at the speed limit and arrive on time, you don’t need to accept the higher risk associated with speeding. Your car might be able to reach speeds above 100mph, but that doesn’t mean you should risk driving at 100mph—especially if you can drive 70mph and still arrive on time.

Investment risk works the same way. You should take on enough risk to accomplish your long-term goals, but no more than that.

Once you’ve determined how much risk you need to achieve your goals, and your investments are in place, you have to be patient and wait for them to grow over the long term. Stay focused on your desired destination and don’t be tempted to take detours. Ready for a real conversation?