Have you ever taken a risk tolerance questionnaire? These assessments are designed to gauge your comfort level with investment risk, often assigning you a numerical score. While they can be a useful tool, it's important to recognize that, like most reductive tools, there's a limit to their usefulness and how much you should rely on them to apply strategies to your real financial picture.
Why Your Risk Tolerance Score Might Be Off
Contextual Factors:
- Age and Life Stage:
- Your mental and emotional risk tolerance might fluctuate throughout your life, and not necessarily in ways that match optimal strategy.
- Within financial planning, it's not unusual to encounter the general view that young people perhaps "should" have a higher risk tolerance, because of their multi-decade investment timeline before retirement, whereas older people approaching or already in retirement have less capacity to withstand sharp downturns, since they may not be able to spare the time required to recover.
- That said, you could easily imagine a risk tolerance questionnaire showing the exact opposite.
- A young investor, despite their long-term time horizon, might have their first access to excess savings and be terrified to lose it. Maybe they have family or cultural background that makes them feel like investing is too much like gambling, and they'd prefer to play it safe and not risk loss.
- Meanwhile, an older investor might have more experience and comfort with market risk. Maybe they've seen multiple crashes and downturns correct, and they now feel more emotionally comfortable with the idea of volatility.
- But the young investor likely really does have more time and future growing earnings to offset short-term market risks. And the older investor really does have fewer earnings years ahead of them, and possibly fewer years to wait out an extended downturn.
- In this case, does it make sense to rely entirely on the mental and emotional aspects of "risk tolerance" when making strategic asset allocation decisions?
- Emotional State:
- Volatile emotions, such as fear or greed, can significantly impact your decision-making.
- A questionnaire taken during a market downturn may lead to a more conservative risk assessment than one taken during a bull market.
- Similarly, survey-takers may demonstrate more optimism or a more cavalier attitude toward the risks of a downturn when they haven't seen one in a while, or if they look positively at the near-term economic picture.
- A person's emotional state might also be affected by factors that affect their personal life in the moment, like recent risks that worked out well, or a series of positive outcomes. Unlike the economic picture mentioned above, these factors might be even less relevant to the actual risks facing a complete asset portfolio.
- Emotional state and tolerance for risk can vary on even shorter timelines than market cycles; an individual's appetite for risk and reward-seeking can vary intra-month, -week, or even intra-day.
- One might be well-advised to think twice before creating a medium to long-term asset allocation that applies substantial weight to factors that can change for these reasons and in these ways.
- Age and Life Stage:
The Illusion of a Single Risk Tolerance:
- Multiple Investment Goals:
- It's unrealistic to assume that you have a single, static risk tolerance for all of your investments.
- Different goals, such as retirement savings, a down payment on a house, or a child's education, may require varying levels of risk.
- Some goals might be considered "nice to have" while others are strictly "need to have" - perhaps the amount of risk an individual or family might take in attempting to achieve one vs the other could call for different levels of risk tolerance.
- Time Horizon, Asset Location, and External Constraints:
- The longer your investment horizon, the more time you have to recover from market downturns, allowing for a higher risk tolerance.
- Conversely, a shorter time horizon may necessitate a more conservative approach.
- Sometimes, these are driven not just by your age and life stage, but instead the location of the assets potentially being invested.
- For example, funds located in what are known as "qualified" retirement accounts like an IRA or 401k are mostly not accessible until age 59.5 without penalty (with a few exceptions). Meanwhile, taxable ("non-qualified") accounts are accessible on an ongoing basis. Realistically, a person could quite justifiably take a different approach within one bucket than the other.
- Even / especially within the taxable bucket, time horizon might not be obvious.
- Imagine a 29-year-old has no identified use for the funds and looks at it as overflow for his or her retirement objective, thus taking a long-term approach with a high risk tolerance to achieve maximum growth, with little weight applied to interim account values.
- Then, by age 32, this person is engaged and soon-to-be married, possibly with a child on the way, and is looking to plan a wedding, buy a house, and plan for day care and education.
- In retrospect, the original time horizon was 3 years and has now dropped close to zero. What was the real risk tolerance for a questionnaire taken at age 29? Was the questionnaire a good way to determine asset allocation, in this case?
- Multiple Investment Goals:
A More Nuanced Approach
Instead of relying solely on a numerical score, consider a more nuanced approach to assessing your risk tolerance. Here are some additional factors to contemplate:
- Financial Goals: Clearly define your short-term, medium-term, and long-term financial goals, and consider matching them to appropriate accounts, assets, and vehicles to achieve them.
- Risk Capacity: Assess your ability to withstand market volatility without compromising your financial security, not just emotionally but in various possible life scenarios.
- Risk Tolerance: Consider your emotional comfort level with market fluctuations, but try to apply more variables to the question than taking it in total.
- Stress Testing: Implement stress testing to see how your portfolio would perform under various adverse conditions. This practical approach provides a clearer picture of how you might react in different scenarios, offering insights beyond a standard questionnaire.
- Diversification: As appropriate, consider the correlations, risk profile, volatility, and liquidity constraints on different asset classes, account types, and vehicles, so that you can manage risk appropriately when unforeseeable changes occur.
- Holistic Approach: Your risk tolerance should be integrated into a comprehensive financial plan that considers all aspects of your financial life. From cash flow and liquidity needs to long-term goals and tax implications, a holistic view ensures that your risk profile is accurately reflected in your overall strategy.
- Professional Advice: Consult with a financial advisor to develop a personalized investment plan that aligns with your risk profile and financial goals.
Being too rigid with your risk tolerance score can limit your financial potential. Flexibility allows you to adjust your investments in response to changing markets and personal circumstances. This adaptive approach can help you capitalize on opportunities while protecting against unforeseen risks.
By taking a holistic approach and considering these factors, you can make more informed investment decisions that are tailored to your unique circumstances. Remember, your risk tolerance is not a fixed number; it's a dynamic concept that can evolve over time.
2024-7233813.1 Exp 11/2026