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!

Riskalyze

Here is a free program, Riskalyze, that creates a portfolio for you which first analyzes your risk tolerance and then creates a portfolio for you. You start by selecting one of the following choices:

Source: Riskalyze

You begin by specifying a "desperation amount."  This is an amount that, if you fall below it, will have a negative impact on your lifestyle - sort of like being in Vegas and keeping in mind that you need a certain amount to make it back home.  Seriously, though, this is an important number to consciously think about as you enter the investment arena.

As you see, I put in a portfolio value of $200,000 and a "desperation value" of $150,000:

Source: Riskalyze

Note the pictures and risk scores.  The old guy has a low risk score of 28, the professional woman a risk score of 45, etc.

Next you get a series of questions comparing alternatives, comprised of taking a sure gain or preferring an uncertain situation of a much higher gain (hit the ball in the upper deck) or dropping back to your "desperation value."

Here is the first alternative:

Source: Riskalyze

As you choose among these alternatives, the bar will eventually fill up and you'll receive a risk score.  I have to admit that I have never liked answering these types of hypotheticals as a means of uncovering risk tolerance.  I would rather look at past behavior and study historical returns.  I will say, though, that Riskalyze's approach may work well for some people and, admittedly, it is based on academic research.

The next set of choices will seek to present you with a case where you start out with your portfolio dropping.  Would you, in that instance, seek to take a chance to regain your position?  It proceeds through these kinds of questions to get at a risk score.

Source: Riskalyze

As you can see, once you get a score it gives you a range of potential returns for a typical portfolio.  The process is based on modern portfolio theory.  Thus, it is saying that the average portfolio for this risk score will fall within the indicated range based on 2 standard deviations from the average.

So, quantifying in this way can be useful for some people.

At this point, Riskalyze asks if you have a prediction for the market or if you would like to use historical returns.  After you pick, it will then construct a portfolio based on your choice in the first graphic above.  What I really like is that - as seen in the first graphic above- it allows for a simple portfolio.  This is the route I would definitely choose unless you want to make managing your portfolio a full time job.

Overall, this is an interesting program and one I think most DIYers will find useful to play around with. Try and see how different it is compared to what you are doing.

Can You Stand the Heat?

The single biggest hurdle for the DIY investor is handling emotions. Depending on the volatility of the market and the size of the portfolio, investors translate a portfolio downdraft into losing the equivalent of a new car, a nice vacation, or their kid's college tuition over a short period of time. Second guessing then eats away at the DIYer psyche. This also works on the upside. After a good week or month, you can't help but focus on the fact that, if you cash in recent "winnings," you can take the profits and buy a big screen TV for every room in the house. The next thing you know you're in la la land dreaming of the things you can get. That's until you run head on into the next 4 x 4.

The away around all the angst ( at least according to those who have opined on the sub market performance of individual investors) is to get a plan and pretty much stick with it through thick and thin. This requires careful thought on how to allocate assets (what percentage to invest in each asset class) among the major asset classes. A truism of the investment world is that this decision is a primary determinant of long-run performance. In previous posts, I have examined questionnaires and quizzes to provide some guidance in arriving at appropriate percentages. I have urged readers to consider how they have reacted in past volatile markets - of which we have had plenty since the start of the decade. How did you feel when the S&P 500 reached an all time low in 2007? How about in March of 2009 when it hit the bottom after free falling for 15 months? Did you hold in, capitulate, or see it as a buying opportunity of a lifetime?

Analyze your feelings and behavior during volatile markets, and it gives you excellent feedback on your capability for taking risk. Also, take into account that, when you answer risk tolerance questionnaires, you are somewhat biased. Answer the same questionnaire in late 2007 when the S&P 500 has had a good upside run and then again in March 2009 when there was "blood in the streets" and you'll come up with different assessments. You'll score higher as a risk taker after a positive market environment.

The bottom line is that personal risk tolerance isn't a fixed immutable number, as is sometimes projected. The more times we venture out of the cave without running into a woolly mammoth, the more of a risk taker we become and vice versa.


An excellent discussion of the influence of recent markets on perceived risk tolerance is covered nicely by Jason Zweig in "Your Money & Your Brain" - a must read for every DIYer.

"How to Think Smarter About Risk"

Moshe A. Milevsky's thought-provoking article "How to Think Smarter About Risk" is must reading for the investment community. His thesis is that human capital is an asset that should be included on the personal balance sheet and incorporated into the asset allocation process. As he puts it, some people are bonds--their incomes hold up even in the face of a 20% market drop--and others are stocks--their incomes go up and down with big changes in the market.

His most controversial premise, it seems to me, is that young people should go lightly on equities because of their erratic income, and vice versa for older people who have converted considerable human capital into financial capital and thereby can take on additional risk. This, of course, is exactly opposite of accepted views on asset allocation. It seems to me that there is a trade-off involved in the point made by Milevsky and the long term returns of risky asset classes.

On another note, his analysis leads me to think that people should think a bit harder about the role of their home in their long-term financial plan. Is it viewed as an asset that will be used to help fund retirement? Then the possibility of a drop in price(or rise in price) should be factored in, whether from the possibility of a reverse mortgage or downsizing.

In any event, Milevsky's analysis raises important points in the critical area of risk management.

DIY Investor Newbie-Risk Tolerance Quiz

These are all the questions together on the risk tolerance quiz. I tried to make them a bit more readable per a viewer request. I strongly urge you to try it out to see if it gives you some insight into your risk tolerance. Next, we will look at building a portfolio.

DIY Investor Newbie - Risk Tolerance

These are the final questions on the risk tolerance questionnaire. I strongly urge you to try it out to see if it gives you some insight into your risk tolerance. Next, we will look at building a portfolio.

DIY Investor Newbie - Step 2 Risk Tolerance (Cont.)

Questions 6 - 10 of the questionairre:

6. How do you feel after making an investment? This is pretty important because it indicates experience. The first time many people make an investment they feel a bit queasy. But with experience they learn that, to paraphrase Annie, "The sun comes up tomorrow." It happens again when the market takes a dive.