Even if you have a lengthy discussion with your planner regarding risk, it is difficult to appropriately quantify your risk tolerance. Many advisers use questionnaires in which they ask their clients questions to solicit their clients’ understanding of how the markets work, and to respond to hypothetical changes in the markets and their portfolios.
Most of these questionnaires are not very good. They have questions about your timeframe for investing, your cash flow, whether you think your income will be better or worse in 3 years, etc. These questions are designed to determine whether you can financially afford to weather a rough patch with your investments. These are important questions for the Financial Planner, but the planner also really needs to know whether the client can handle the rough patch mentally and emotionally. These are two separate capacities to handle risk and should be addressed separately.
Even if the questionnaire has the right sorts of questions, and identifies the different types of risk capacity, another real problem is that no hypothetical questions can substitute for the very real losses suffered by people in a bear market. Seeing it on a questionnaire and seeing it on your statement is definitely not the same.
It is one thing for a person to read the questionnaire and agree with the statement “I can handle losing 50% of my portfolio over a two-year span, if in the end I can achieve my goals.” It is quite another for the person to have seen the value of his brokerage account statement go from $100,000 to $50,000 over a six or eighteen-month period, like if you had invested only in the S&P 500 index in March of 2000 or September of 2008.
Despite these drawbacks, we still use questionnaires to gauge how much clients and prospective clients know about the financial markets, and to have them think through and attempt to quantify their goals and risk tolerances. We spend more time having open-ended discussions to try to gauge where clients stand.
Another problem with some questionnaires is that they only define risk as a large loss of money in a short time period. There are other, more important risks that are rarely addressed. The most important risk to address, after all, is the risk of not achieving your goals.
You can minimize your risk of losing a large amount of money by not investing in stocks. This strategy may backfire, however, if you don’t earn enough on your money to reach your goals. If you do not earn enough on your money to outpace inflation, the real purchasing power of your money will shrink over time.
The concept of risk is one that must be carefully and thoroughly discussed with your Financial Planner. You must consider the impact that a large loss could have on not only your financial plans, but also on your mental and emotional wellbeing.
