The Myth of Risk Tolerance

Of the unicorn handdrawn unicorn on faded paper

The financial industry has leaned on a term called “risk tolerance” for as long as I have been in the profession and likely been around well before me. Risk tolerance is supposed to be an investors “appetite” for risk, and on an emotional scale, how much of the risk/reward equation one can handle. The problem, and the myth of risk tolerance comes in how we as professionals attempt to obtain that information. If you have worked with a Financial Professional in your lifetime, you may have been subjected to a “Risk-Tolerance Questionnaire”.

A Risk Tolerance Questionnaire (RTQ) poses to the taker a series of questions attempting to gauge how one may feel about certain monetary outcomes. You can go on almost any website of a major financial firm to find one. They will usually start by obtaining your time horizon. After that, you will find questions like these: (this one is from Vanguard’s investor website):

From September 2008 through November 2008, stocks lost more than 31%. If I owned a stock investment that lost about 31% in 3 months, I would … (If you owned stocks or stock funds during this period, select the answer that corresponds to your actual behavior.)

Now that seems like a straight-forward way of looking at your past behavior to determine how you may act in the future. Of course, this is only one question out of 10 to 15 typically asked. The rest are various forms of also obtaining information about how you might behave in the future.

I prefer other methods of determining risk profile rather than RTQ’s because they leave out such huge chunks of information about the way you answer those questions. For instance, if you had gotten into a car accident on the way to your Financial Advisor’s office you may be feeling more aggressive. Not in the driving sense of course, but people who are upset tend to throw more caution to the wind. On the flip side, if you had just won a contest for $1000 you may be more conservative. People who are on the end of a positive outcome tend to me more conservative in the moment, we don’t want to gamble the euphoria away. These up’s and down’s happen in life daily. The different ways in which each person perceives risk and reward changes not only daily, but by our own life experiences and environment.

An evidence-based approach focuses more on “Risk-Capacity” and “Risk-Need”. Capacity and Need refer to our own monetary ability to afford a loss or risk of certain investments. You wouldn’t’t put money you have saved for a down-payment in a year into the newest tech start-up IPO, right? You don’t have the capacity as the loss of that capital would impact your ability to buy the home, car or boat. Need focuses on how much risk and reward you need to take in order to succeed. A retiree who is taking 4% a year from their investments needs a 5.5% annual rate of return assuming a 3% inflation rate to never draw-down their original principal over 25 years. Based on this simple math you can have an appropriate conversation about asset-allocation on which asset mix or strategy may provide you with the needed return over your time horizon.

Allocating your portfolio to a questionnaire tainted by your emotional swings or how you perceive risk at that moment may leave you with a portfolio you don’t like tomorrow. This isn’t to say some of our past investing behavior isn’t relevant to how we allocate moving forward. Our brains are extremely complicated and cause us to frequently make irrational decisions with money and investments. However, using an evidence-based risk-needs and capacity approach may help you determine more appropriate allocations and strategies that hopefully lead you to better outcomes.

The views are those of Robert Jeter CFP®, CRPC® and should not be construed as specific investment advice. Robert regularly speaks to the public on behavioral finance and how it affects investment decisions. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Investors cannot directly invest in indices. Past performance is not a guarantee of future results.

Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and, when sold or redeemed, you may receive more or less than originally invested. No system or financial planning strategy can guarantee future results.

Securities and advisory serviced offered through Cetera Advisors LLC, member FINRA/SIPC. Cetera is under separate ownership from any other named entity.