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Monday, October 28, 2013

Comment on Risk Tolerance Questionnaires

Here is a good, short article from the online Financial Planning site on risk tolerance questionnaires by Alan S. Roth:  Why Risk Tolerance Questionnaires Don't Work.  For those who might not know, risk tolerance questionnaire are a favorite tool of the financial planning crowd, frequently presented with an aura of scientific precision.

But this scientific precision is too simple.  In fact, at the extreme, some people are taking unnecessary risk!

In the article, William Bernstein (author of The Four Pillars of  Investing) poses the question: “if you’ve won the game, why keep playing?”

This question is especially relevant today with the S&P 500 and other indices at all-time highs.  It takes me back to the year 2000 when I attended an event for investment professionals and a young investment professional was bragging about his $3.0 million portfolio of internet stocks.  Someone asked why he didn't sell and take a profit, and his response was "with a portfolio going up $50,000/month, why would anyone take a profit?"

This young man was hardly the exception.  Back then, many had a portfolio they could have retired on comfortably at a young age but let ride. 

Later, someone told me he eventually finally sold out after the portfolio had dropped to $150,000.

The same behavior frequently occurs with state pension funds where they become fully funded, or close to fully funded, as markets rise but then become more aggressive with their asset allocation.  All of this points out the astute observation, made in the article, that risk tolerance isn't some stable magnitude that can be measured by a risk tolerance questionnaire.  Instead risk tolerance changes as markets change.

I would add that there is a difference between a highly volatile market that is trending upwards versus a highly volatile market trending downward!


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