By: Larry MacDonald

When someone opens an account at an investment firm, one of the first things they will likely be asked to do is complete a risk-tolerance questionnaire (which will then be used by the advisor to recommend an asset allocation). Some observers think these questionnaires are not the best way to determine people’s risk preferences.

As William MacKenzie writes in his book, The Unbiased Advisor, risk preference tends to vary with the state of the stock market. During a bull run, people will express a high acceptance of risk; during a bear market, they will express a low acceptance. So the responses to a questionnaire are not necessarily a good guide to how investors will react as market conditions change.

Moshe Milevsky says risk tolerances are ephemeral and can swing from conservative to aggressive depending on the investor’s mood, even within a period as short as a day. In an interview published in the Journal of Financial Planning (November, 2009), he remarked: “I tend to be much more risk averse in the morning before my latte than I am after my latte. You can’t make decisions based on fleeting frames of mind.”

It also seems to me that the questionnaires overlook the fact investment decisions are taken not so much on an individual basis as on a joint basis – i.e. in the background is the investor’s spouse. The investor who signed the questionnaire may very well be able to stay the course when equities are down 40% but the spouse may not. Capitulation during bear markets could be not just a matter of individual investors loosing their nerve but also of investors responding to spouses’ pleas to cut losses.

What are the alternatives to the use of risk-tolerance questionnaires to determine asset allocations?

One seems to be to de-emphasize risk assessment and simply start out with a conservative allocation when investing for the first time. Thus, William Bernstein writes: “If you’ve never been tested before, I strongly urge that you encounter your first bear market conservatively invested.” That’s a somewhat interesting suggestion considering young persons starting to invest are usually counseled to tilt heavily toward equities.

Milevsky suggests using more objective criteria for setting asset allocations – like the investor’s type of job and whether it is bond-like (e.g. tenured professor) or stock-like (commissioned-sales person). That would seem to make sense. But I wonder if people who gravitate toward secure professions tend to have low risk tolerances to begin with and when the market tanks, they may be more likely to abandon or cut back on an overweight position in stocks.

Mackenzie says investors and advisors should be programmed away from seeking the highest return possible for a given level of risk tolerance and just seek the rate of return required to meet the objectives of the retirement plan. Often they can get there with a modest level of risk and return – even though the questionnaire said they could live with more risk. Why take on the extra risk if it’s not needed to provide an adequate living standard for the retiree?

It also seems to me investors and their advisors have to realize that when investors go into stocks, they are signing up for a cruise through the occasional gale where the waves can get 30 to 40 feet high. That is, maybe risk assessment is not as important as working on mental preparation and state of readiness.

Like the actor preparing for a role on stage, or an army practicing military maneuvers for the possibility of battle, investors and advisors have to continuously rehearse what they will do when the storm comes (e.g. disregard the headlines and actions to take to be greedy when others are fearful). Psychology does affect investor’s decisions but rather than fear it, shape it to one’s advantage. A good grasp of the market’s history will help in this department. And so will the actual experience of market cycles.