Identifying your risk tolerance

This was in response to a recent press request that our office received.  The journalist, Don Korn of Black Enterprise Magazine, was writing an article about the importance of identifying your risk tolerance prior to investing.  His publisher was looking for an online risk tolerance questionnaire that they could direct readers to.

The problem is that all risk tolerance questionnaires are inherently flawed.  They may provide a decent starting point for an investor or adviser, but they are generally too easy for the user to "game" their answers.  Most investors taking such a questionnaire, have a predetermined notion of what they believe to be their risk tolerance.

The internet is certainly not at a loss for risk tolerance questionnaires.  Most of the major money sites have some version.  One of the better ones is found at MSN Money.  The questions are interesting, and not necessarily in the format that you might expect for an investment risk tolerance questionnaire.

A great example:

You take a job at a fast-growing company, where you are offered these choices. You pick:

• a five-year employment contract.
• a $25,000 bonus.
• a 10% pay increase on your $100,000 salary.
• stock options (the opportunity to buy company stock at a set price) with a current value of $25,000 but the chance for appreciation.

The beauty of a question like this is that it makes you think about financial risk in areas outside of your investment portfolio.  It's still obvious which answers are "conservative" and which is "aggressive," but there's more to it.  The five-year contract is stability.  That one is pretty straightforward.  But consider the $25,000 bonus vs. the 10% pay increase on your $100,000 salary.  At first blush, it's obvious.  $25,000 is more than $10,000 (10% of $100,000).  But here's the great part.  What this question asks in a way that is not so obvious is, do you think long term benefit or short term gain?

The 10% pay increase will exceed the value of the $25,000 bonus in three years.  Not to mention that future pay increases will then be based on a larger amount.  Have you read the book, "Don't Eat the Marshmallow Yet!"?  It's the classic story of the benefit of delayed gratification.  Brilliant stuff.

And the last response?  It's delayed gratification with risk.  They say that there are not right or wrong answers with these things, but for anyone investing for a long term goal, like retirement, this is the correct answer.

Problems with Risk Tolerance Questionnaires

This isn't just the questionnaires, it's any sort of risk assessment, including outright asking an investor, "what's your risk tolerance?"

The unfortunate reality of risk tolerance is that it is heavily influenced by recent market movements and the nightly news in general.  When, like recently, the nightly news is dominated by bad economic news and market volatility, it causes investors to retreat towards conservatism.  Even more dangerous is that the opposite is true when markets are roaring.  In the late 90s, I was a young broker and remember vividly people telling me that their risk tolerance was “whatever the highest” was.  Investors generally have some understanding that risk and return are correlated.  In good markets, high risk means high returns; vice versa in down markets.  The danger, of course, is risk tolerance questionnaires may result in investors chasing returns in high markets and retreating away in down markets.

This is why it is important for risk tolerance questionnaires to have less obvious questions, like the one above.  If they are simply questions like, "what is your goal:  growth, income, capital preservation" it is too easy for the investor to game the test towards what they believe to be their risk tolerance.

It is critical to have an ongoing discussion of the true risks, worst of which is the inability for an investor to meet their long term goals.  The short term risks are the “sleep at night” factor involved in short term volatility.

If the risk tolerance is not properly identified, the true risk is that the resulting investment policy will likely not be appropriate.  If it is too aggressive, the real risk is that the investor will not have the fortitude to stick with the long term plan due to short term volatility.  If it is too conservative, the investor runs the risk of not achieving long term goals due to lack of performance.  They may sleep at night as their money barely moves, but sleep very poorly when they realize that they did not earn enough to fund a comfortable retirement.

Comments

[CiaranFromChance]

Hey nice blog guys! Art DInkin turned me on to it. I agree with your assessment of these risk profile questionnaires. You almost need to trick people, so they don't game the system.

I chuckled when you wrote about investors in the 90's saying their risk tolerance was, 'whatever is highest.' I remember those days quite well.

I've lost clients over the years, especially during times of extreme market volatility and one of the things I've come to realize was the classical risk profiles many of these clients filled out hadn't correctly diagnosed their attitudes towards risk. And as I got to know many of them, through the years, I was able to really get a better sense what type of investors they really were.

So to wrap it... I agree with what your saying here.

And I think firms have to do a better job of creating risk profile questionnaires that are less straightforward and gameable. Maybe take a page out of eHarmony's book (never been to the site, just guessing:)

[CiaranFromChance]

btw, Stumbled it.

[CiaranFromChance]

Hello, is there anyone home?

[Eric Toya - LWM Blog]

Ciaran,
Hi, and thank you for your comments and for stumbling this post. Sorry for my lack of response. I didn't have an opportunity to get online over the weekend.

I am very impressed with your blog. It looks like you have been at it for quite some time.

[CiaranFromChance]

Hey Eric,

No worries, thought maybe there was something wrong with the comments field. I would add the plugin that allows commenters to be notified when there are follow up remarks on a thread.

I just happened to come by and saw that you responded, it works better if I'm alerted by email when a response is added. It's makes for a more interactive experience and will help your blog grow.

Glad to see there are a few of us out here, it seems there are more and more CFP bloggers popping up, although it's still only a handful.

Drop me an email if you need any help, I've been through many of the ups and downs and could help you with any questions you might have.

thanks,
Ciaran