Introduction

Formulate a Financial Plan

Know Your Net Worth

Manage & Minimize Debt

Accumulate Assets

Budget to Live Within Your Means

Understand Investing Basics

Plan for Retirement

Insure People & Property

Deal with Financial Advisors

Review Your Employment Contract

Make Plans for Your Estate

Make Good Decisions

Conclusion

As noted earlier, the golden rule of financial decision-making is: Always make decisions based on simultaneous and objective consideration of risk and return.

The golden rule leads to some fundamental questions: Can we be objective about risk? Do we all feel the same way about risk?

Not surprisingly, it turns out that we all have different attitudes toward risk. We may feel very differently about the same risk. Most of us are somewhat conservative and don’t like facing risk at all. We have a low appetite, or a low tolerance, for risk. Economists describe us as risk averse. That is, we exhibit a natural aversion to risk.

In contrast, a smaller percentage of the population falls under the category of gamblers or risk lovers. Risk lovers have a large capacity to tolerate risk or a big appetite for risk. These are the people who go bungee diving, jump out of planes, and generally tempt fate. Their reward for these daredevil activities is the adrenalin rush.

Because people have different attitudes toward risk—some of us are more averse to risk than others and some of us love risk to varying degrees—we don’t all react the same way to the same risky situation.

Let’s set up an experiment to distinguish people’s relative levels of risk aversion. Begin by arranging a scenario with a fixed level of risk, and then measuring how much reward, for example, how much money, must be offered to each person to get them to agree to take that risk. The most risk-averse among us will require the highest reward to accept the risk, whereas the risk lovers will accept the risk just for the thrill of it, with little to no financial reward. The reward each person demands in order to accept the risk can be called that person’s risk premium. We can sort our test subjects by risk premium, from highest to lowest, yielding a risk preference ranking. The people at the top of the list are the most risk averse, and hence require the highest risk premium to accept the risky deal. At the bottom of the list are the risk lovers.

Government regulators (and common sense) require brokers and financial advisors to understand each client’s risk tolerance. This is meant to ensure clients receive products that match their risk preferences.

A highly risk averse investor should end up with a very conservative (low risk) portfolio and only a person with low risk aversion (high tolerance for risk) should undertake very risky investments.

 

Measuring Risk Tolerance

In practice, brokers and investment account administrators use responses to questionnaires to measure our risk tolerance. Some of the questions seek to determine our investment horizon; how long we intend to maintain the investments before we need access to our money. Other questions seek to determine our attitude to risk-taking. Time horizon questions have more to do with our ability to accept risk than with our emotional willingness to accept it. Both ability and willingness to take risk are relevant in determining the risk profile for our portfolio.

The concept of risk aversion is perfectly sensible in theory: If we can measure risk tolerance we should do so. But the questionnaires used to assess risk tolerance are flawed. It’s not always easy for investors to answer the questions accurately. It’s not that they don’t want to. It’s because the wording of questions may bias the answers, or because investors aren’t sufficiently in tune with their feelings about risk to provide accurate answers.

In fact, investors are likely to answer the same questions differently depending on their state of mind, which may be highly influenced by external conditions. For example, an investor may feel extremely vulnerable immediately following a market crash, leading to conservative answers to the questionnaire (once bitten, twice shy). That same investor, six months earlier, during the giddiest moments of a spectacular bull market, may well exhibit overconfidence, giving answers consistent with a very high tolerance for risk.

Typical risk tolerance questions are similar to these[2]:

1. I must begin withdrawing money out of my investment in:

          A. Less than 3 years

          B. 3–5 years

          C. 6–10 years

          D. More than 10 years

 A client selecting (D) has a longer investment horizon and therefore greater ability to withstand the negative effects of market volatility compared to a client selecting (A).

2. Which would you prefer to invest in?

          A. Highly diversified portfolios

          B. Individual company stock

          C. single startup company

Here, the answer (A) suggests high risk aversion, while (C) suggests low aversion to risk.

Another potential question might be:

3. If the stock market declined by 20% tomorrow, would you:

          A. Sell all your stock investments?

          B. Sell half of your stock investments?

          C. Buy more stock?

In this example, a highly risk averse investor would be expected to choose (A), while a risk loving investor might choose (C).

On the surface, these questions appear to reveal risk aversion. But as already noted, our risk aversion is affected by circumstances. The upshot is that there’s a Catch-22. The only way we can accurately answer questions designed to reveal our risk tolerance is if we already know our risk tolerance. Many people don’t understand enough about the emotional context of decision making to answer these questions objectively. Unsophisticated financial advisors also don’t get it. For them providing the questionnaire is equivalent to checking a box for the purposes of compliance and legal liability coverage. They don’t understand, and may not care about, the limitations of the process from a risk tolerance identification perspective.

If you want to sleep well at night, you must carefully consider your comfort level with risk. Try to imagine how you (and your partner) would feel under various market downturns. Then ask yourself: Are my current circumstances, for example: investment choices and insurance coverage, consistent with my feelings about risk? Your evaluation of risk preferences must consider how you’ll feel when investments sour!

There are analogies to these concepts in other aspects of our lives. For example, we may enter our first romantic relationship without any regard to the potential downsides (very low risk aversion). But by the next relationship we’re likely to be more guarded—more reluctant to commit fully to what we know is an emotionally vulnerable scenario.

It’s easy to get caught up in discussions of negative outcomes. But most of us don’t take risks for the sake of risk. We take risks because we expect some reward or return.

 

Related Links:

Schwab Investor Profile Questionnaire

 


[2] If you’d like to see more of these, simply search online for “risk tolerance questionnaire” and explore the search results.


11