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?

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.

-Rick Francis

What about the customer? Well, not all advisors are like you. They just want their commissions. Risk be damned.

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

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.”