What Investor "Risk Questionnaires" Get Wrong
WRITTEN BY: Gideon Drucker, CFP® AIF® ECA
On a recent phone call, a prospective client told me that her last advisor asked her to fill out a risk tolerance questionnaire and because she was deemed “conservative” by the software, she hasn’t been investing in the stock market.
I almost fell off my chair. Not because she should or should not be investing in the stock market. That’s not the point here.
It’s the idea of financial advisors relying solely on risk tolerance questionnaires that is BAFFLING to me.
As I explained to this person (who actually was a physician), imagine going to the doctor and having the doctor choose a medicine/remedy based on how YOU think you got sick rather than running tests, asking deeper questions, or gaging family history. What’s the point of going to an expert if that expert is just going to rely on the misconceptions, half-truths and Wikipedia answers that you came into the appointment with?
The point of hiring a professional is not to validate your “beliefs” but to advance them to get to a better outcome. Instead, a risk tolerance questionnaire asks us to take you as you (think you) are regardless of whether that’s actually what’s BEST for you.
Let’s peel this back.
Risk “tolerance” refers to how much risk you are emotionally comfortable taking on in your portfolio. It is not about your financial circumstances or reality...it’s just how you feel about investing. Your risk tolerance is therefore totally dependent on your knowledge & confidence and is something that can be changed through education, better planning, and a greater awareness of investing realities.
My job is NOT to see how comfortable you are with investing and to react accordingly. It’s to challenge your understanding. My job is to understand how you NEED to be investing in order for you to reach your goals and then educate you enough to change what you perceive your risk tolerance to be in order to square it with the facts.
In my experience, most people have a risk “tolerance” that is entirely surface level and ready to be changed. Risk “tolerance” is paper thin. Clients that have told me they’re “conservative” on an initial call realized by the end that they just didn’t really understand that stock market investing doesn’t mean day trading but rather could mean owning the entire market as a whole. That’s a simple example but it comes back to the fact that words like “aggressive” and “conservative” mean entirely different things to different people.
Risk capacity is what I prefer to focus on. Risk capacity refers to how much you can actually stand to lose based on your cash flow, your liquidity, your upcoming big-ticket expenses, and your income.
Risk capacity should dictate how you invest and that can only be accomplished through proper planning.
For example, if you have $100,000 in the bank and we determine that your 6-month cash cushion is $50,000, your upcoming house renovation will cost $25,000 and we want to leave some room to cover potential tax liability....well, guess what, you have ZERO risk capacity with this tranche of money. It should all be set aside in cash or cash alternatives: High Yield Savings, Money markets, CD’s etc. You cannot afford to risk/lose this money because you actually need it in the short term.
Alternatively, if you are 45 years old, have $800,000 in your 401k, you make $500k, you own your own home, and have ample liquidity....well, you can stand to handle quite a bit of volatility in the short term, understanding that you don’t actually need access to these funds for 15+ years. Your risk capacity with this account therefore is substantially higher than a risk tolerance “questionnaire” might lead you to believe by asking you “to feel” questions in the abstract.
Moral of my story? Risk “tolerance” is nothing but a starting point to understand someone’s preconceived notions around investing.
Only then does the real work begin!!
As always, you can schedule a 15 Minute Right Fit Call here.