What if There is a Fire?

[This is #4 in a series of Meditations on Risk.]

If you believe in the traditional asset allocation story, then the single most important task you have is to determine what percentage of your long-term investment money you should place in the stock market. According to the tradition of our fathers, this one decision will determine over 90% of your long-term return.

Nothing else compares to it in terms of importance!

With so much riding on it, you would think that we would develop good tools to help answer the question, but we really haven’t. While many REAL financial planners have long understood that there is a LOT that we don’t understand about risk [that is why it is called RISK], most of the investment industry is still running around with a false sense of confidence in things like risk tolerance questionnaires.

These questionnaires are a few “scientifically” designed questions to magically determine your tolerance for risk. That answer will determine how much you invest in the stock market and that will be the most important decision you make. It might sound silly to rely on a 10 minute exercise to make the most important decision of you investing life, but this is a “best practice” in the industry.

As crazy as it sounds, for some in the industry this questionnaire was even too time consuming. I remember at a training session at a major brokerage firm, a grizzled old veteran stock broker pulled me aside:

Carl, forget about those questionnaires. This is how you determine what portfolio to put someone in. Tell them that there is a high-rise condo building that they have decided to move in to. There are 2 condo’s available and price is not an issue. One is on the top floor. Great view of the city, but 20 floors up. Might be hard to get out if you needed to in a hurry. The other is on the ground floor, no view, but you could get right out in case of an emergency.

Ask them which one they would choice. If the pick the top floor, they are aggressive. The ground level, they are conservative.

This line of thinking would be humorous if it wasn’t so common. One of the common assumptions about risk tolerance is that financial risk is similar to other types of risk.

So if you pick the top floor, hang glide, surf, or rock climb, then you should have all your money in hedge funds.

It is simply not true. In fact, the entire discussion misses the point. The issue is not so much how much risk you can handle; it’s how much return you need.

What condo you pick tells us nothing about what you need to make your plan work.

Using a risk tolerance questionnaire [or the condo test] to make what many believe to be the most important decision of your financial life is silly.

By Carl on 09.03.09 > Link

Tagged as: asset allocation, risk tolerance questionnaire

  • I'd think a risk-tolerance questionnaire would be far too abstract to be of use for the simple reason that a questionnaire has no gravity, there is no real risk involved. Do folks play "pay" online poker differently than they do free online poker?
  • ChadCastle
    Carl,
    I'm not sure that throwing out a risk tolerance questionnaire altogether is the best approach, although I do agree that they have some HUGE shortcomings.

    I recall back to when the risk questionnaire was not necessarily "best practices." Early in my career I remeber asking a prospective client whether or not they were an "aggressive" or "conservative" investor. The prospect answered, "Aggressive, of course." Much to my surprise, after employing the use of the worthless questionnaire, I learned that his version of "aggressive" meant 5 year CDs instead of 90 day CDs. So, at least in this once instance, the questionnaire did prove to be helpful.

    I think RobBennett may be right in that a client's answers to the questions tend to ebb and flow with whatever the market has done in recent history. This makes any static questionnaire become less effective over time. So then, the question of the day is what is the best measure or guide to determine a clients true risk tolerance?
  • Dylan
    Market risk tolerance to me is a lot like temperature tolerance. It constantly changes based on other factors. I don't mind being cold in the summertime as much as I might in the middle of winter. If I'm well nourished and hydrated, I can usually tolerate more extreme cold or hot temperatures.

    But I certainly don't try to live my life constantly shy of my tolerance for extreme temperatures; I try to balance practicality and comfort. This way, when I'm hit with an unexpected change, I have some wiggle room well before it becomes intolerable. I think it makes sense to try to do the same with tolerances for market risk and try to find a point that is comfortable yet still practical. In other words, I wouldn't want to avoid so much market risk that I'd have to make impractical sacrifices in order to still achieve my financial goals. That may not be comfortable either. But I also don't want to be uncomfortable for no practical purpose.
  • Dylan
    I also want to add that I do think there is some value in risk tolerance questions or questionnaires, but it's kind of like trying to locate the edge of a cliff in the dark. It's nice to know where that edge might be, but whether your talking about risk tolerance or the edge of a cliff, you're probably better off not even getting close unless you have a very good reason to be there.
  • Rick Francis
    You make a very good point that there isn't a good reason to take on more risk than you really need to take. However, I suspect most people won't have the luxury of taking a very safe investment strategy as they didn't start saving early enough. A few people can just buy TIPs and forget about risk entirely, regardless of their risk tolerance, but most others will need more returns than guaranteed investments can give.
    I think a good advisor needs to measure their client’s risk tolerance to prevent them from falling prey to the behavior gap. Other than asking how do you measure risk tolerance? A survey done in a bull market might not be very accurate when a bear market hits, but is there a much better alternative? My thought is that the best you could do is to give them the survey and then formalize their responses into a written plan. Then if they start panicking during a market downturn you bring out that agreed upon plan of action. Hopefully, that will calm them and they will not sell at the worst possible time.

    -Rick Francis
  • I don't know why you don't like the idea of the Condominium fire. It's perfect. No work for the advisor. No thinking by the advisor. No time wasted by the advisor. Take the client's cash and invest it, or tell the client what to do. Work done; fee collected.. How can an advisor do better than that?

    What about the customer? Well, not all advisors are like you. They just want their commissions. Risk be damned.
  • You're asking all the right questions, Carl. This entire series is top-notch not because it gives all the answers (which would be fake) but because it asks the most important questions.

    Our understanding of how stock investing works is primitive. That's the first thing that we all need to come to accept. We don't know it all. It's not even a close call.

    One thing that we have done in recent decades that is wonderful is to learn that successful investing is long-term investing. That's a big deal. The mistake was in thinking that the words "buy-and-hold" possess magic power, that just saying the words will turn us all into long-term investors. No. The job is to figure out what it takes to practice buy-and-hold in the real world.

    I believe that the focus on the risk tolerance of the individual is a mistake. It's a factor. But the truth is that no one really knows how he is going to react to a big price drop until he lives through the experience. We can't psychoanalyze ourselves. So looking at personal risk tolerance doesn't get us to where we need to go.

    I find far more promise in the idea of looking at how the riskiness of the market differs in different price environment. Market risk is not stable. Stocks are far, far more risky at times of high price than they are at times of moderate or low price. So I think that the logical way to proceed is for all investors to lower their stock allocations when the riskiness of stocks goes off the charts. The goal should not be to keep the stock allocation constant (Passive Investing) but to keep the risk level constant (Rational Investing).

    A stock crash can destroy your retirement hopes if you are going with a 80 percent stock allocation at the time prices crash. It has not nearly the same effect if you are going with a 20 percent stock allocation. I believe that the key to helping people assess risk is letting them know how much more risky stocks are when prices are high or insane and urging them strongly to lower their stock allocations in those circumstances (that is, to invest non-passively).

    I see the Passive Investing concept as being pretty much the entire risk problem. Take away Passive Investing, and stocks are just not that risky anymore (there has never been a stock crash at a time of moderate or low prices).

    Rob
  • >>The issue is not so much how much risk you can handle; it’s how much return you need.<<

    Perhaps better, it's how much you can afford to lose, and with what likelihood. Sometimes the return level that a person needs is well above what is prudently sustainable, and the best thing an advisor can say, "Sorry, but you'll have to get by on less, or find other ways to supplement your income. If you want returns at that level, you have a XX% chance of eventual ruin."
  • Well said - "The issue is not so much how much risk you can handle; it’s how much return you need" I wonder how many people will miss that line
  • markcliff
    Hi Carl.
    A thought-provoking post which addresses two issues: the importance of a portfolio's long-term (strategic) asset allocation and Risk Tolerance Questionnaires.

    Firstly, I agree wholeheartedly with an approach to investing based on strategic asset allocations being the greatest predictor of investment outcomes. It follows that knowing the historic return and volatility characteristics of a particular portfolio (over varying time periods) is for me of great importance as it will be able to show the probabilities of various outcomes over the individual's investment horizon.

    As for Risk Tolerance Questionnaires, I think that the good ones are critical in sifting out what an individual's "peace-of-mind" portfolio might look like. Whether or not such a portfolio would contain sufficient inflation-beating assets over the time horizon to meet the individual's needs is another (related) issue entirely.

    I would not feel comfortable recommending the top floor portfolio to someone who likes to live very low down - even if they say that they need it. Rather, I would encourage the person to both move a few floors higher, but at the same time to moderate their "needs" or "wants".

    I think that ignoring a person's risk tolerance completely in favour of a myopic focus on need is dangerous in the extreme. Both aspects need to be considered.

    Keep up the interesting posts

    Cliffy
    Cape Town, South Africa
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