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Why Risk Tolerance is a Flawed Concept

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Look up risk tolerance on Google and you will see more than 149,000,000 results. Most of the higher ranked listings are actually investment risk tolerance quizzes. These short quizzes provide the impression that risk tolerance can be precisely determined merely by the answers to a few questions.

In reality, your tolerance for investment risk is mostly governed on the emotional plane and can’t be measured by questions about risk on the rational or intellectual level. In general, trying to quantify risk tolerance with a high degree of specificity is a ruse.

Risk Tolerance is a Flawed Concept

The entire idea that investors have a certain tolerance or “appetite” for risk is flawed. Regardless of how much (or little) “taste” someone has for market fluctuation, if the desired planning outcomes are not achieved, the risk level isn’t appropriate. To me, it’s like asking if someone wants to consume chocolate or broccoli. Ultimately, if it’s the broccoli that generates most of the investment returns, your “appetite” better include a large portion of broccoli or you will likely fail financially.

Moreover, referring to market fluctuation as risk misses the mark. What risk should really mean is not achieving your personal financial goals. Is a 20% allocation to stocks “less risky” than the inverse? Most risk questionnaires would say so, but not if you need the higher returns to reach your goals. In that case, there is more actual “risk” in the portfolio with the lower stock allocation percentage.

Related:  What If Investments Don’t Matter Much, but Savings and Behavior Do?

Pass on the Quiz

We have used a variety of risk tolerance questionnaires in the past. However, we stopped using these a few years ago after concluding that, at best, these presented a snapshot of how someone observed investment risk at a particular point in time. The value of these questions as a prospective tool for determining investment policy is minimal in my opinion. Investing is always about balancing what you need in terms of growth/returns on one hand and what you need in terms of safety on the other.

Ok, so if not some type of standardized quiz to help set investment allocations, then what? In my view, if investors want a starting place, begin with the assumption that you will need the majority of your investments assets allocated to stocks for the duration. Why? Because cost of living (inflation) increases impact everyone, regardless of your “appetite” for risk. No one can escape.

Speaking of escape, many well-heeled investors believe that they have a better fix on the appropriate risk tolerance than others. Believe me, biases and cognitive errors impact everyone. These are hardwired in all of us and the only real distinction is between those who acknowledge this and those that don’t. Start there.

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