Are investors thinking about the wrong type of risk?
The investment industry defines risk as volatility but for investors the real risk is not achieving your goals.
When I left university, my first job was at a financial planning firm. They had a few regulatory hoops to jump through that ensured they were doing their due diligence and understanding their clients. One of these hoops was a Risk Tolerance Questionnaire (RTQ).
A risk tolerance questionnaire is common practice in financial advice firms, in robo-advice and even self-help tools for new investors. These risk tolerance questionnaires do what they say on the box. It is a short questionnaire – usually between 8-10 questions, that measure how much risk you can tolerate, or the degree of volatility you can withstand when it comes to investing.
Based on your answers, you’ll be assigned an asset allocation.
Is there another way?
Compare this to risk capacity. Unlike risk tolerance, it is the amount of risk that an investor must take to reach their financial goals.
That is the key difference – risk tolerance does not take into account what you actually need to get to your goals, and only considers your reaction if markets fall. Ultimately, if you are only taking risk tolerance into account, whether you reach your goals or not is entirely left up to chance.
At Morningstar we’re proponents of goals-based investing. We acknowledge that investments inherently carry risk. And that risk does need to be managed. But ultimately an investment is simply a vehicle to assist us in reaching our goals. That might mean taking on more risk than we might feel comfortable with if it means achieving our goals. That outweighs the uncomfortable feeling of market volatility.
How a risk tolerance questionnaire works
This is an example of a question that was found on a risk tolerance questionnaire distributed by a large financial services firm.
You have an initial investment portfolio worth $100,000. If your portfolio fell to $85,000 within a month, would you:
- Sell all of the investments
- Sell a portion of your portfolio to cut your losses and reinvest into more secure investments
- Hold the investment and sell nothing, expecting performance to improve or
- Invest more funds to lower your average investment price?
There are a few problems with this. The first is that this situation is completely hypothetical and is asking what you would do. The truth is, none of us truly know how we would react in stressful situations. How we answer and how we actually respond might be completely different.
When I look at this question, the logical answer for me is 4 – I would invest more funds to lower my cost basis. I have a long-time horizon, I have a stable salary and I am not reliant on investment income. I can afford to wait for markets to recover.
In previous market drops, I have averaged down most of the time. But sometimes I’ve also just held the investment and sold nothing (option 3).
Humans are complex by nature and often make illogical decisions. A questionnaire doesn’t allow for irrational decisions driven by fear.
Another problem with this is that how you react to this loss has nothing to do with your investment goals. If volatility makes you nervous and you feel like you would sell all your investments, that realistically does not change the rate of return that you need to achieve your goals.
If you were to be assigned a portfolio allocation based on your answer to this question, you might take on too little or too much risk as it completely ignores your time horizon or required rate of return. In other words – risk tolerance is blind to your actual investment goals.
My attempt at a risk tolerance questionnaire
I completed a risk tolerance questionnaire. I am married with no children – that meant that I could take on less risk than if I’m single with no children. It also told me that I should take on a conservative allocation because I have never borrowed money to invest before. These two facts may indicate my willingness to take risk. They have nothing to do with how much risk I should take.
Ultimately the questionnaire placed me in the balanced category. Balanced tells me to take on 50% growth assets, and 50% income assets and has a minimum time horizon of five years.
I have almost 40 years until I retire. I do not need half of my portfolio in defensive assets. My portfolio may go up and down over the short-term but ultimately that doesn’t really matter if I don’t need the money for decades. I have high confidence that I don’t need access to the money because I’ve built up an emergency fund. Something the risk tolerance questionnaire didn’t ask about.
I’ve defined my goals, and my rate of return that I need to live the retirement that I want. That return is higher than what a balanced portfolio offers me.
How do investors understand their risk capacity?
Understanding your risk capacity involves going through the portfolio construction process. The first step is defining your goals. If you don’t know your destination, there is no way to design a portfolio to get there.
Then, you can calculate your required rate of return – which is the alternative to the output that you would get from a risk tolerance questionnaire. The return needed to achieve your goal will guide your asset allocation and the mix of defensive and aggressive assets to get you to your financial goals.
And knowing and understanding your goal and what it takes to accomplish it can provide ballast when markets turn volatile. Going through the portfolio construction process provides a level of understanding about the relationship between risk and reward that a risk tolerance questionnaire won’t.
It isn’t that a risk tolerance questionnaire is bad. One of the biggest challenges as an investor is focusing on the long-term and not responding to the emotions elicited by volatility. But they solely focus on how an investor responds over the short-term and don’t provide any orientation to long-term goals. A good financial adviser combines the questionnaire with context about their client’s life, responsibilities and future goals. Viewing the answers to these questions in isolation from your situation will only result in having investments in your portfolio that do not align with the outcomes that you are looking to achieve.
A detailed explainer of the Portfolio Construction process is explained in this episode of Investing Compass.