Risk is something investors can’t afford to get wrong. Gamble too much and you may rack up losses; play it too safe and you may stunt your portfolio’s growth.
Risk tolerance questionnaires are supposed to pinpoint your acceptable level of risk to help you select suitable investments, but the forms may do more harm than good.
[See: 10 Ways for Investors to Buy the Market.]
“The problem with risk tolerance questionnaires is that they try to quantify something that’s not quantifiable,” says Mark Painter, founder of EverGuide Financial Group in Berkeley Heights, New Jersey.
These questionnaires generate investing suggestions based on the answers the investor provides. When investors’ actions don’t align with how much risk they think they can tolerate, the result is an imbalanced portfolio.
Painter says that determining a client’s risk profile is more art than science and requires in-depth discussion, something a questionnaire can’t replace. A human advisor can “really probe the client to find out if their answers truly match their risk profile,” he says.
That’s fine if you have a financial advisor you can turn to, but if you use a robo advisor or manage your investments directly, you’ll only have the questionnaire to go on. In that case, recognizing the main flaws of risk tolerance questionnaires can help you more accurately assess how much risk you can stomach.
Perspective. One thing the questionnaires fail to account for is how changes in the market may influence your willingness to take long-term risks.
Jane Taubner Barney, senior client advisor at TFC Financial Management in Boston, says risk tolerance questionnaires are often completed by investors who aren’t currently experiencing the risks they’re being asked about. These investors can only speculate how they might feel about taking a loss during a down market, which can skew the person’s perception of what a comfortable level of risk is.
“Many investors tend to express a greater willingness to take risk when they haven’t been through a significant market correction,” Barney says. “Unless an investor has experienced a market crisis, it’s difficult for them to know how they’ll react.”
In other words, the questionnaire can only gauge how risk-tolerant an investor is under the current market conditions. If volatility spikes and stock prices drop suddenly, that same investor may not have time to minimize potential losses by shifting into safer assets.
Robert Wolfe, managing director at United Capital in Fort Lauderdale, Florida, says investors should avoid weighing recent performance more heavily than older data. This recency bias can lead investors to assume the market will always look the way it does today.
Wolfe says that’s problematic for an investor responding to a questionnaire after a period of strong portfolio growth or a streak of losses. The result may be an asset allocation that swings too aggressively or too conservatively to achieve the person’s goals.
Emotions. Another shortcoming of risk tolerance questionnaires is their inability to filter an investor’s feelings, says George Villa, president of Villa Tax Advisory Group in Groveland, Illinois.
“The majority focus on the emotion of the investor without asking questions that have real value, or quantifying where your money is actually going,” Villa says.
[See: 13 Ways to Take the Emotions Out of Investing.]
Investors who follow their emotions often make mistakes. Villa says that investors tend to rely on their own experiences rather than consider the big picture. What often happens is they “operate on emotion and follow the crowd.”
Your emotional state at the time you respond to the questionnaire can have significant implications for your portfolio, particularly if you don’t have a human advisor who can help guide you through rough patches in the market.
That’s a problem, says Barney, because investors need someone objective to keep them focused on their goals when their portfolios lose value. Investors who are scared of the market’s behavior and have no one to ask about whether selling makes sense are in a tight spot. And the odds of an investor timing the market perfectly are slim.
Investors who sell need to time the market right twice, Barney says. Once when they’re getting out, and then again when they’re getting back in.
When emotions cloud their judgment, investors run the risk of breaking the cardinal rule of investing — buy low and sell high. Risk tolerance questionnaires simply aren’t equipped to account for how emotions can drive decision-making.
Context. The biggest flaw is that the questionnaires lack context, says Brendan Mullooly, an investment advisor at Mullooly Asset Management in Wall, New Jersey.
“When investment outcomes are viewed in a vacuum, it’s tough to ascertain what really matters,” Mullooly says. “If the market has gone up, it feels like you should be getting more aggressive, but if it’s gone down, it feels like you should be more conservative.”
In the worst-case scenario, Mullooly says that the questionnaire can end up as a tool for chasing performance and timing the market, which can be detrimental to a portfolio.
He says investors will get a better idea of risk tolerance by putting it in the context of a comprehensive financial plan. When you have a plan in place, your risk tolerance is determined by your goals and lifestyle, rather than market gyrations.
Mark Friedenthal, founder and CEO of Tolerisk, a subscription-based investor risk assessment tool, says getting a clear view of your risk tolerance means accounting for both your willingness and ability to take risks. That ability is tied directly to your current and future cash flows.
For example, Friedenthal says you must consider things like your current savings rate, expenses, the tax status of your investments and various retirement income streams. If you expect to buy or sell a property, sell a business or start one, or receive an inheritance at some point, those things could also influence how much risk you can reasonably take on.
“Risk tolerance is a Goldilocks exercise — you don’t want it to be too high or too low,” Friedenthal says.
If it’s too high, you might compromise some important goal or won’t be able to stomach the associated volatility, he says. If it’s too low, you won’t benefit as much from your savings and investments in retirement.
When the accuracy of a risk tolerance questionnaire is in doubt, a human advisor may be the answer.
[Read: What Human Advisors Do That Robo Advisors Can’t.]
Villa says a trusted advisor can customize a plan to your needs, but that doesn’t mean you should place your future entirely in someone else’s hands, either.
“You need to be a steward of your own money,” Villa says.
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How Risk Tolerance Questionnaires Can Steer You Wrong originally appeared on usnews.com
