Why risk tolerance questionnaires don’t work

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Typically, financial planners have clients take a risk tolerance questionnaire to determine their appropriate asset allocation. They ask questions such as how the clients behave when markets surge or plummet, and how many years they have until retirement.

Though all of this sounds very logical, the problem is that we are emotional beings rather than logical ones. If we were logical beings, we would see the consistent data of dollar-weighted fund returns lagging the returns of the funds themselves. This shortfall is behavioral and, in part, comes from under- and overestimating our ability to take risk.

The Wall Street Journal researched these questionnaires and found that our perception of risk is anything but stable. It’s impacted daily by whatever emotions we may be feeling at the time, and whether we are happy or sad or anxious or angry. Flirting can make us feel empowered and more risk tolerant, while fighting with our spouse can make us feel more risk averse.

When stocks plunged in 2008 and early 2009, many investors found their tolerance for risk wasn’t as high as they thought. Now that stocks are near an all-time high, investors are feeling an increased willingness to take risk. That may explain why fund flows into equity funds have turned positive only since January of this year.

These surveys have an even greater problem than our unstable view toward risk. As bad as the measure of risk willingness is, they never measure the need to take risk. Considering clients can’t take their money with them when they pass on, they may have very little if any need to take on risk if they can fund their desired lifestyle with low-risk assets like TIPS. As author and financial theorist William Bernstein puts it, “if you’ve won the game, why keep playing?”

That is not to say that risk profile questionnaires are pointless as they can serve the purpose of beginning a discussion. You can ask clients how they would feel if their stocks lost half their value, but make sure you are letting them know it would actually hurt far more than they imagine.

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct instructor at the University of Denver.

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