What is Your Risk Tolerance?

How can you assess your investment risk tolerance? Like many advisors, we use risk tolerance questionnaires to facilitate client conversations about risk. You can take a look at a popular risk

tolerance quiz here. Some advisors use the results of these questionnaires as a shortcut to place investors into a one of four or five model portfolios. That is, the results of a short quiz determine an initial investment allocation. However, that approach ignores the investor’s values and goals.

To encompass those topics, we use the results of a client’s risk tolerance questionnaire as a springboard into a much broader discussion of risk. We discuss the risk of a client’s current portfolio and the risk they need to take to achieve their goals. We often see that one’s risk tolerance score is far different than the risk of their current portfolio and the risk they need to take to reach their goals.

If a client’s portfolio is considered higher risk (heavily invested in equities) and the questionnaire results show a more conservative investor, we begin by discussing their previous investment history and responses to market movements. We want to determine how they handled past situations when the market declined dramatically or where volatility spiked for a prolonged period because that can be very predictive about how they will behave in similar situations in the future. We want to avoid having a client take on so much risk that the next market downturn prompts them to sell and flee to cash.

For those with little appetite for volatility, we’ll discuss how conservative their investment portfolio can be and still enable them to reach their goals. Rather than coming up with a risk tolerance number that quickly dictates how we invest, there’s plenty of back and forth. The process of identifying a client’s risk tolerance involves honest conversations, education about market history, and sometimes requires the re-visiting of one’s goals or trade-offs.

Of course the problem with these quick risk tolerance questionnaires is that the results can be very much informed by the current market. Tested in the midst of a bull market, investors tend to say they can accept plenty of risk. And, you guessed it, during a free falling market, investors are likely to be more worried about risk. In some sense, these questionnaires don’t tell us so much about how much risk the investor should take on, but rather whether the investor views the current market as risky or not.

Don’t get me wrong. A questionnaire is useful, but it’s just step one. A trusted advisor will ask clients about their reactions to past market events and dig deep to identify their goals for the future. Only that way can the resulting asset allocation and investment plan put the investor on the best course to stick with the plan when markets fluctuate and ultimately reach their long-term goals.

Risk tolerance questionnaires are just tools to inspire the deeper, honest conversations that serve as the foundation of an investment plan.

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