If you’ve made an investment, it’s likely that someone has asked you to compete a so-called “risk tolerance” questionnaire.
Is this just more paperwork, or is it something you should pay attention to?
The “right” answer is to say that we investment types use risk tolerance questionnaires to protect you (the investor) from putting your money in anything that has more risk than you may be willing to tolerate.
The answer no one will admit in public is that we use those kinds of questionnaires as much to protect the investment company as it is to protect the investor.
If the market goes significantly down after an investment firm has put your money in the market, you could come back and say, “Hey, I didn’t sign up for a 25% loss!” But if the firm had you complete an investment risk tolerance questionnaire, which said you understood the market could go up or down 25% in short order, you wouldn’t have a very good argument that you didn’t know what you were getting yourself into.
I am not saying that risk tolerance questionnaire are not useful tools. They are. They just have limits you would be wise to appreciate.
For one, who really knows their risk tolerance? You may have never gone through a bear market (in which the average price of the securities declines 20% or more).
And even if you have gone through a bear market, you haven’t gone through all of them. It’s easy to look years into the rear view mirror and talk about what you should or should not have done during the last bear market. The reality is that each bear is different and the circumstances leading up to and surrounding it are all uniquely apocalyptic sounding at the time.
Also, your reaction to a bear market changes with the size of your assets. I’ve talked to any number of people who had a few thousand dollars in their 401K and the boast of “not even paying attention” to the market busts of 2002 or 2008.
That same person will have a significantly different reaction when he’s got several hundred thousand (or even a million) dollars at risk. The blasé attitude is nowhere to be found; now it’s all doom, misery and gloom during bear markets.
Finally, age affects your risk tolerance (I believe) more than anything else. I’ve worked with clients long enough to see more than a few make the transition from daredevil risk-taker to cowardly lion care-taker. Why would you think age would affect your tolerance for risk any less than age affects your tolerance for lots of other things?
So, yes, it can sometimes feel forced to attempt to measure something as deep-seated and mysterious as your tolerance for risk (during a traumatic event no less) with a questionnaire.
That’s why working with an advisor you can trust is so important. There will likely be times when you have to “borrow” his or her faith in the markets, because yours is running on empty.
So a questionnaire is a great place to begin. I’d suggest a good eye to eye conversation about the reality of bear markets and how you (and your advisor) will react is an even better step to take.
Can investment risk tolerance questionnaires (and hopefully the conversations they spawn) be a bit awkward and forced? Yes.
But useless? No way.