When I meet with a new client, many expect the first thing I’ll do is have them take a risk profile questionnaire to determine their risk tolerance.
These questionnaires try to determine how you feel about risks and rewards in order to recommend what percentage of your portfolio should be in risky asset classes like stock funds.
I tell my clients that I don’t think these questionnaires are worthless—I say they are worse than that and actually dangerous. Let me use one of the best questionnaires I’ve seen to illustrate.
- This seven-question profile from Vanguard took less than 30 seconds for me to complete, and it indicated that I should be 70 percent in stocks and 30 percent in fixed income and cash. As of a few days ago, I’m actually only 45 percent in stocks and 55 percent in fixed income and cash, and not about to change. Here are the three reasons:First, willingness to take risk is not stable. There is a fair amount of research demonstrating we tend to think we are risk-takers in good times only to head to the hills in bad times. I took this questionnaire during a time the stock market was near an all-time high. I’ve studied behavioral finance for more than a decade, and I’m not so sure I would have answered the question the same way in March 2009. This unstable view of our risk tolerance is why, according to Morningstar, investors underperform funds by 2.49 percent a year by buying high and selling low. Advisors also turned to cash after the financial plunge.
- Next, ability to rebalance is impacted by one’s target allocation. I truthfully answered that, during market declines, I tend to sell portions of my safer assets and invest the money in riskier stock funds. I rebalanced a few times during the market plunge of 2008 and 2009, but it proved to be the hardest thing I’ve ever done with my portfolio. Buying more stock index funds at that time was like getting punched in the gut. It was this hard even though I had less than half of my assets in stocks. There is no doubt in my mind that if I had been 70 percent in stocks, I wouldn’t have had the courage to risk the little bit I had in fixed income. Daniel Kahneman won the Nobel Prize in economics for his work in prospect theory, which revealed that we get far more pain from losing a dollar than pleasure from making a buck. Because rebalancing is so critical, I tend to work with my clients to set a more conservative allocation they will stick with than a more aggressive allocation they won’t.
- Third, I’ve never seen a questionnaire deal with one’s need to take risk, which is completely different than one’s willingness. I tell clients that dying the richest person in the graveyard isn’t my key financial goal. Because I live fairly frugally, I’m now rich with less money, and have very little need to take risk. As I view it, as long as the U.S. government survives, I can support the desired lifestyle for my family. I advise clients not to take risks they don’t need to take.
Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning Magazine.