Does Your Risk Tolerance Matter?

By Brad Thomason, CPA

 

If you’ve ever had a meeting with an investment rep or an insurance agent to buy a financial product of some type, it’s likely that they asked you questions about what kind of risk tolerance you had.  In fact, I hope they asked you: because it’s the law.

The requirement to inquire about risk tolerance ties back to the consumer protection element of “suitability.”  Essentially what that means is that people in the financial industry aren’t supposed to be putting investor dollars into things that are risky if the investor isn’t comfortable taking on the risk.  And how will they know what the investor’s thoughts on the matter are?  They have to ask.

But like a lot of things that become routine, I often wonder how many financial types actively recall why the question is there.  Because even though I do think it’s important to have consumer protection measures in place, I’m not sure how much bearing that question – or the answer – has to do with the actual movement of the money.  In other words, while I understand the conceptual need to address the question, I’m just not sure how much actual utility the answer has when it comes to the actions that presumably follow (i.e. moving money from A to B).  Here are a few thoughts on the matter:

  1.  The term “risk” doesn’t have the same definition in the academic world that it does on Main St.  That’s significant because Wall Street and the regulators more or less go with the academic version.  In that lexicon, risk is an inferred mathematical property which is related to the probability of an outcome being in line with what’s expected based on the historical behavior of the market or markets it’s a part of(it’s OK if your response to that was, “Huh?”  Most people in finance don’t actually understand this distinction either).  But on Main St, risk has to do with whether or not somebody’s going to lose some money.  If the market is down 30% in a given year and your mutual fund is also down 30%, then the academic view says that you do not have any investment-specific risk.  The implication even being that the 30% loss is OK.  Yet, I know very few actual people who would conclude that a 30% loss is OK; nor would they be likely to view the activity that got them that 30% loss as being not risky.
  2. Even if you can get past the definitional difference, that still doesn’t mean there’s a good way of measuring the risk.  The questions that financial pros have to ask are usually posed in terms of “low, medium or high risk.”  I defy anyone to tell me what those terms actually mean.  Since they are all relative terms, they have no meaning whatsoever outside of a comparison.  Even then, they are inexact.  Now, keeping in mind the consumer-protection DNA, one can see that if the risk level on the form is marked as “low” and the broker’s response is penny stocks, we have a mismatch.  So this framework can provide some context for what NOT to do.  But it really doesn’t do much for pointing the way to what should be done.
  3. Just because you think you have a tolerance for risk, that doesn’t mean that you have to go out looking for something to gamble on.  Presumably you have a financial plan that calls for you earning x% each year on a sustained basis.  Do you really have to take on huge levels of risk to get there?  If you have even remotely reasonable expectations about what your portfolio can earn over the long-term I bet you really don’t have to take on that much risk to get there.  Often high risk levels are assumed to correlate to high returns (in practice this is a much looser correlation than the academic world thinks is the case; and that’s when there’s any correlation at all.  But we’ll have to tackle that one another day).  However, I would respectfully submit that if you have determined there’s a need to earn 40% a year from now on to reach your goals, you need to go back to the drawing board.  With more reasonable goals, if you look at assets beyond just the stuff that’s traded on the exchanges, you may be pleasantly surprised to find that it really isn’t necessary to turn this into a roulette exercise.  Even if you have nerves of steel and can handle it.
  4. Finally – and I know I harp on this all the time – if you have hit the point where you’ve saved what you are going to need, why are you still exposing it to risk at all?  Put it someplace safe.  Do not lose your win while trying to rack up a bigger war chest that you don’t even need.  Please.  Once you reach the point of preserving your victory, your tolerance for risk should be all but irrelevant.  Because your exposure to risk should drop to somewhere around zero.

Just because a financial pro asks you what your risk tolerance is, don’t make the mistake of thinking it has much to do with what your next steps ought to be.  Financial decisions are best made when they are a response to what needs to be done.  So the driving factor about whether or not to put your money in X should be whether or not X can get you the result you are after.  Not your ability to stomach exposures to loss that may not even be necessary in the first place.

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