fbpx

Why Risk Tolerance Questionnaires May be Hazardous to Your Financial Health

 

I’ve long been suspect of those risk tolerance assessment questionnaires that financial advisors ask you to complete before signing off on an investment. Apparently, my suspicions are well-grounded as even Michael Kitces, renowned retirement researcher, agrees they aren’t really all they should be. He writes at length about it in The Sorry State of Risk Tolerance Questionnaires for the Financial Advisor. They do not ask the right questions.

If risk assessments could provide real value, they should take into consideration your age, how close to reaching your retirement date you are, and your actual assets. For example, if you have a final salary pension from the government, you could probably take more risk in your own investment portfolio given you have a guaranteed stable income base. If you have no pension plan, you would then be relying more heavily on your investments and Social Security (or the state pension in the UK) to provide. So you might need to buy an annuity to create that stable income floor. But if you are young in your 20’s, 30’s or 40’s you have time to recover from vicious bear markets and can ride them out in almost all cases. So it is fine to go heavy on stocks. But if you are in your 50’s and 60’s you may have little to no time to recover from a sizable market crash. This makes equities a much riskier choice simply because you are older, regardless of what your risk assessment says.

First, until you’ve actually lived through a brutal bear market and watched your investments get sliced in half, you don’t know a thing about your risk tolerance. It is one thing to answer a question in the serenity of an office. It is quite another to open your statement and see your investments decimated. Second, by taking this sort of survey you may tend to assume that your risk tolerance is now settled for the rest of your life. In fact, your tolerance for risk is likely to vary throughout your life.

Our tolerance for risk should not only change as we age, but also with the sums invested. After all, why take unnecessary risks if you’ve already won the game? If you are close to achieving your net worth goal, why risk a 90% stock/10% bond portfolio?  You won’t be happy to think you’ve achieved your goal only to find a market crash delays your plans for retirement for many years. Once you’ve reached financial independence, you can congratulate yourself and invest purely to maintain an annual income, keeping pace with inflation.

Your risk tolerance should naturally shift and change as you get older and as your retirement pot grows. And we should be doing what makes financial sense. Get over any squeamishness that is irrational. A young millennial should be heavily invested in stocks. Yes, stocks are volatile and will go up and down. So get tough and get used to it. As JL Collins says in The Simple Path to Wealth, stocks are the most likely to succeed so you need to be invested. Yes, it will be a roller coaster ride.

Then, I’d add, as you are older and have more at stake, that strategy no longer makes sense. It seems crazy to take unnecessary risks that you may never recover from. Your earning years and investing time horizon shorten as you age. The shorter your investing horizon, the less time you have to recover. So, the less risk you should take. The longer your investing horizon, the more risk you can take because you actually are taking less risk simply by having a longer time frame. As you get nearer to reaching your retirement income goal, it makes more sense to protect what you’ve built. So, you’d get more conservative whether you are conservative by nature or not. The likelihood of great rewards for being tough in a downturn has been reduced so the risk aspect does not make sense for most of us.

Another reason why risk tolerance questionnaires muddy the waters. What good is it to you to find out that you are highly risk averse and want to keep only 20% in equities if that doesn’t help you reach your overall financial goals?

This is the problem with these questionnaires. First, they do not really determine how risk averse you are in the first place. They are entirely hypothetical. Second, knowing your risk tolerance does not necessarily help you make the best investing decisions. Investing based on our emotions and feelings (fear!) has never been a smart strategy. In fact, research shows that the majority of investors underperform the market precisely because they react in fear. They panic and sell in a downturn when they would be better off holding.

Yes, I understand that you can be so risk averse that in the first tiny downturn you sell at a loss. But to counter this behavior, you need to get smarter and realize that downturns are normal market fluctuations. The market will recover and grow beyond where it was before the downturn. In fact, during the downturn is the best time to add to your equities because stocks are “on sale”. Give yourself a pep talk and stay the course. Your perception that something is risky because it is volatile may be the actual problem. Volatility and risk are not the same thing.

Given that risk assessments are useless tools for helping one make the best financial decisions, I’d ignore any answers that you get. Instead, insist that your fee-only, fiduciary investment advisor (who by law must have your best interests at heart) tell you what your ideal risk tolerance should be based on age, invested assets, additional revenue streams and the amount of time you have before planning to retire. If my risk profile doesn’t fit the ideal asset allocation from a purely non-emotional, financial standpoint, then I should consider whether I need to shift my own thinking in order to do the smart financial thing, whether that is to get more conservative or more aggressive. I might also need to consider other strategies to reduce risk, such as having diverse sources of income.

I have now thrown down the gauntlet for financial advisors to pick up!

For the record, I am not a financial advisor and cannot give financial advice. This article is meant to get you thinking and also prodding your own fiduciary fee-only financial advisor to help you make better choices not rooted in irrational fears.

Talane Miedaner
Talane Miedaner is a Master Life Coach and the founder of LifeCoach.com. She is the international bestselling author of Coach Yourself to Success: 101 Tips for Accomplishing Your Personal and Professional Goals (McGraw-Hill, 2014), Coach Yourself to a New Career as well as The Secret Laws of Attraction.