No Shortcuts in Evaluating Your Investment Risk

Early in my career, I worked for a big brokerage firm. Back then, I made a habit of seeking out the veteran stockbrokers and quizzing them about their careers. One day, I had a pretty extensive conversation about risk with one of those grizzled Wall Street guys.

I’ll never forget it.

“Let’s assume you’re moving into a high-rise condominium in Florida, and there’re only two units for sale,” he said. “One is the penthouse — beautiful view, amazing balcony, but it’s 37 floors up. The other is a garden-level walkout unit. Not the same view, but on the first floor, and your door exits right onto the street.”

He continued, “You want to know the risk tolerance of your clients? Just ask them which one they’d choose. If they choose the penthouse, they can handle a lot of risk. If they choose the garden unit, they’re very conservative investors.”

It’s a really great story, and I’ll always remember it. But it’s also total garbage.

There are many stories like this one, basically shortcuts that people try to use to determine how much risk they can handle with their investments. Maybe you’ve heard the one where your hobbies determine the risk you’re comfortable taking? If you’re a private pilot or a rock climber, the legend goes, then surely you can handle lots of investment risk.

This year’s scary markets have led to lots of talk about how you should go about deciding how much risk to take. The way this decision manifests itself is through the percentage of your money you decide to have in the stock market.

Unfortunately, you can’t just push a button and get an easy answer to the “how much risk” question. But that doesn’t keep people from trying. If you’ve been to one of the major brokerage firms in the last 20 years, you may have completed what’s called a risk tolerance questionnaire. You get a series of 10 to 20 questions intended to figure out how much risk you can handle, like:

I would consider selling my investment if it’s down:

a) 20 percent

b) 30 percent

c) 40 percent

d) 50 percent or greater.

In theory, based on your answer, you should know how you’ll react during a scary market.

Last week, Ron Lieber wrote about the hopeful work of a few companies that are pushing to make risk tolerance tools that will be helpful for advisers. But there’s a dark side, too, around this thing called a risk tolerance questionnaire, including how it has been used and, unfortunately, how it’s still being used today.

Many in the industry use these questionnaires as a shortcut to plug investors into a prepackaged blend of mutual funds without really considering the specifics of annoying, messy things like values and goals. In other words, it’s a lazy way of making a basic diagnosis and then writing you a prescription.

The questionnaire is seen as a way for advisers to cover themselves in case risk appears (the market is down) and clients don’t like it. Advisers can point to the questionnaire and claim they were just giving the client what they wanted.

Traditionally, the problem with these tools has been that if you answer these questions during a bull market, you tend to answer, “Risk? No problem, bring it on!” But if you were to answer the same questions during a really scary market, you’re more likely to say, “Risk? Yikes, get me out of here!”

If you or your adviser is not careful to examine the last few times you felt elated or scared about your financial life, you could be in danger of doing the wrong thing at exactly the wrong time. Remember, our natural temptation is always to buy high and sell low — to be greedy when everyone else is greedy and scared when everyone else is scared. And that’s the exact opposite of what Warren Buffett suggests we do.

These tools may sound intelligent. There may even be really intelligent people administering them. But the truth is, they are just a more sophisticated version of the condominium example.

Let me be clear: I don’t think questionnaires are completely useless. In the hands of a thoughtful adviser, they provide a starting point for useful conversations. But the way they are often used in the industry, as a push-button answer to how much risk you should take, is just plain wrong.

At this point, you may be wondering, “If risk tolerance questionnaires can’t tell us how much risk to take, then how do we make that decision?” The only right answer to that question is to build a plan based on your own values, goals and financial situation. Specify clearly the resources you have, the money you have to invest and the goals you want to hit.

You may find that you only need to have 20 percent of your assets in stocks to get the return you need to reach your goals. You may find you need 80 percent. Whatever you discover, if reaching your goals requires more risk than you’re comfortable taking, the next logical step is to reassess your goals. Have some real, serious conversations about what trade-offs you’re willing to accept.

Now that we’ve been reacquainted with scary markets, use what you’ve learned to get clear about what you can handle in terms of risk. Sure, put yourself through one of the risk tolerance questionnaires, but also make sure you go through the process of building a plan. Figure out what you need in the stock market to meet your goals. Finally, have an honest conversation with yourself about whether you can handle the risk. And if you can’t, then go back to the drawing board and try again.

This commentary originally appeared February 22 on NYTimes.com

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© 2016, The BAM ALLIANCE

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Carl Richards, CFP®

Carl Richards is the creator of the weekly Sketch Guy column in The New York Times and is a columnist for Morningstar Advisor. Carl has also been featured in The Wall Street Journal, Financial Planning, Marketplace Money, The Leonard Lopate Show, Oprah.com and Forbes.com. His simple but meaningful sketches served as the foundation for his first book, "The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money."

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