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Risk tolerance: There is more to it than just a questionnaire

May 2, 2014
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By Matt McCoy

Learn more about Matt on NerdWallet’s Ask an Advisor

Let’s take a trip back to 2008.  You have been tossing and turning at night after spending the day watching the stock market decline…again.  As you lie awake, you think to yourself “We’ve spent all of these years saving as much as we could and now it’s starting to disappear!”  You can’t bear to watch any more of your investment value “disappear”, so you decide to do something about it.  The next day, you find yourself completing one of those online risk tolerance questionnaires.  Among the questions it asks you are your age, at what age you plan to retire, and, most importantly, how much loss of principal you can tolerate on your investments.  At this point, your tolerance for loss is pretty small – if not non-existent.  Your answers lead the tool to calculate your risk tolerance as conservative.  If your risk tolerance is conservative, how did you end up in this situation in the first place?  Let’s go back to 2006 – the last time you completed a risk tolerance questionnaire.

It’s late 2006 and you have watched several years of positive stock market returns, not to mention a pretty good year thus far.  All is well and you are feeling pretty good about your investments.  You run through the same questions regarding your age, retirement and tolerance for investment losses.  Only this time, your feelings regarding investment losses are starkly different: you feel as though you could comfortably tolerate a loss of 20%.  Your answers lead the tool to calculate your risk tolerance as aggressive. What gives?

As human beings, we have a tendency to rely heavily on the old adage “what have you done for me lately”.  I’ll admit that choosing the time periods above as an example may be a bit extreme, however I’ll bet this is relatively close to reality.  Why did you choose to take less risk in 2008?  Because the market was in decline and you had experienced losses.  Why did you choose to take more risk in 2006 and 2007?  Because the market had been going up and you saw no reason it wouldn’t continue on that path.  The questionnaires do a great job of getting us to think about how we feel about risk presently, but unfortunately they cannot remove the emotion – or our short term memory.  So how do you reconcile this?

The first step is to understand the difference between tolerance for risk, ability to take risk, and need for risk.  As mentioned above, risk questionnaires will help you determine your tolerance (or willingness to take risk) – assuming you can remove recent emotions – however they cannot determine your ability to take risk or your need for risk with great accuracy.  Let’s take a quick look at the interaction between these three terms.

Your ability to take risk and your need for risk is determined by your current progress toward your financial goals – are you ahead or behind?  For example, assume you have accumulated twice the amount that you need for a comfortable retirement.  Assume further that we use your risk tolerance from 2006 – aggressive.  So here is what we end up with for our three risk definitions in this example:

  • Risk tolerance:  aggressive
  • Ability to take risk:  high
  • Need for risk:  low

Your ability to take risk matches that of your aggressive risk tolerance as determined by the questionnaire, but what about your need to take risk?  This is actually on the complete opposite side of the risk spectrum!  It appears as though we have a discrepancy – so which risk definition should you focus on?  Well, if the purpose of investing is to fund your financial goals, you should focus on the need to take risk.

In reality, there will likely be a need to reconcile the differences between the willingness to take risk, the ability to take risk and the need for risk.  In the above example, you were willing and able to take more risk than you needed to reach your goals.  This example could very well have worked by flipping the answers.  You could have ended up with a conservative risk tolerance while having a high need for risk (indicating that you are far behind your goals).  In either case, you would be forced to either re-assess your willingness to take risk or consider adjusting your financial goals.

While this exercise does not include all risk factors to be considered, it is a good starting point for developing a comprehensive view of risk tolerance.  So the next time you sit down to complete that questionnaire, remember that you are just getting started.