The Myth of Risk Tolerance

Not much more needs to be said, other that "common sense," still has a place in our world today.. Great vid-clip in addressing the common-sense issues of risk tolerance, as used in the investment sales process.

paul t

I am a crocheter who doesn't keep all her money in cash, but I had a good laugh at your example. : )

Thanks for the comment, it is great to finally meet the crocheter that all
the risk tolerance questionnaires say doesn't exist!
I have now meet a skydiver that only wants CDs and a crocheter that owns
stocks.

Awesome post. No need to explain more.

Risk tolerance is about feelings and emotion. Financial planners need to work with real people and their "present" feelings. As Carl indicates, a risk tolerance measure is simply a barometer on changing emotions, and this is important because the emotional environment in which your client LIVES is an important filter that affects the receiving and understanding of advice.

Weather changes in most areas of the country and cycles into a "climate". A financial planner is a guide who can help a lot in storms and in unusual weather. He can help his clients understand the difference between a passing storm and normal climatic cycles.

As to Carl's suggestion that a financial plan should be primary, that is true, but can restrict us to the population of clients who can pay for a comprehensive financial plan. Most middle income clients don't want a comprehensive financial plan. They gulp at the time required and the price tag of the plan. For middle income folks, we need to master the technique of developing what used to be called a "yellow pad" financial plan. This method needs good basic data. With it, an experienced CFP can sketch in a few goals in minutes. This has to be a two-way process leaning heavily on "points" of agreement and emphasizing ongoing, regular review.

Thought provoking piece, Carl, as usual.

Great concept. Thanks for clarifying and illustrating the susceptability of risk tolerance assessment to the market conditions.

I agree with your points but using the word "need" makes me uncomfortable since based on the net worth of most Americans their need far exceeds what any plan with even a small chance of success could provide.

Doug: that may be more an issues of unrealistic goals, lack of
discipline, or just the hard reality of someone situation. Of course
you could address meeting your goals in ways other than taking risk.
You could save more, retire later, live on less in retirement,
etc...in fact helping people manage these tradeoffs (pulling the right
lever if you will) is what financial planning is all about.

But the fact remains that the level of risk you take should be based
on what you "need" to have the greatest chance of meeting your goals.
The less the better.

good video, though I prefer text because it takes less time, and there wasn't much in the way of graphics.

I have a piece that complements what you said here:

Personal Finance, Part 11 — Your Personal Required Investment Earnings Rate -- http://alephblog.com/2008/01/26/personal-financ...

David- thanks for the feedback (text vs. video) we will continues to provide
both for everyone. Thanks for the link to the article.

Carl,

Great post. I couldn't agree more with the idea that any attempt at formulaic risk assessment must be coupled with a plan. One idea I didn't hear in this post and haven't seen on the site is a discussion of the nature of risk itself. The CAPM based financial definition is deeply flawed and disconnected from the behavioral issues you highlight. I think there is a critical relationship between understanding risk, the ability to understand you're own risk tolerance, constructing an appropriate portfolio and behaving appropriately to manage it.

Keep up the good work. Thanks.

@john: thanks. You are right, knowing yourself and your tendencies
(overconfidence, optimism biases, etc..) is critical. As far as the CAPM, I
am getting there :-).