By Jason Zweig | May 3, 2013 6:13 p.m. ET
Image Credit: Christophe Vorlet
With the stock and bond markets butting up against record highs, and volatility not far from all-time lows, that little red devil on your shoulder is whispering in your ear that it’s safe to take more risk again.
Can you count on your broker or financial adviser to tell you how much risk is right for you?
Last year, the Financial Industry Regulatory Authority, which oversees how investments are sold in the U.S., began explicitly requiring brokers to assess how much money clients can accept losing. As a result, you might have been asked to fill out a “risk-tolerance questionnaire” recently.
Many of these questionnaires are unhelpful at best and harmful at worst, say experts on investing and the psychology of risk. Fortunately, there are ways to do better.
That might be useful if your risk tolerance were an integral part of who you are, no more changeable than your IQ or your shoe size. Nothing could be further from the truth. Your behavior isn’t determined solely by who you are; it’s also a function of the situations you are in.
“You’re trying to measure something multidimensional and inherently unstable with a one-dimensional, stable tool,” says Rob Brown, chief investment strategist at United Capital Financial Advisers in Newport Beach, Calif. “You’re calling it a land animal when in fact it’s a creature with wings.”
Researchers have shown that how much financial risk people are willing to take is associated with: how an investment has been described to you; whether you are feeling happy, sad, anxious, angry or disgusted; how much money you had between the ages of 18 and 25; whether, if you are a man, a woman recently touched you on the shoulder; whether, if you are a woman, there are a lot of men in the room; how well the market has done lately; which country or culture you come from; how long ago you ate your last meal; whether you smoke; how much you weigh; whether you put your feet up on a table when you were thinking about the risk; whether at least 75 people have died in an airplane crash in the past three days; whether the sun is shining; how urgently you need to go to the bathroom; where you got the money you are investing; whether you smell a pleasant aroma before your decision; how many positive adjectives were in an article you just read; whether you have recently been embarrassed; whether you consumed a sugared drink in the past 10 minutes; what time of year it is; whether your favorite soccer team won or lost the big game; and so on.
In short, your tolerance for risk depends on countless changes of context, many of which you might not even be conscious of at the time. The notion that anyone can measure your risk tolerance by asking you a few basic questions is ridiculous.
Even financial advisers don’t seem to believe the results of these questionnaires. A recent survey of more than 5,000 advisers by Cerulli Associates, a research firm in Boston, found the advisers believed 26% of clients had an “aggressive” tolerance for risk and only 14% of clients were “conservative.”
A parallel survey of more than 8,000 clients, however, found that only 8% regarded themselves as aggressive, while 29% considered themselves conservative.
“There’s a difference of opinion between advisers and clients on what they think ‘risk’ means,” says Scott Smith, a research director at Cerulli.
Advisers tend to focus on how large a loss the clients can afford, while the clients think mainly about how painful a loss would feel.
So, if your financial adviser asks you to fill out a risk-tolerance questionnaire, use the occasion as the springboard for a deeper discussion.
Ask why he thinks a few silly questions say anything useful about you. Voice your worry that the run-up in the markets might be fooling you into thinking you can stomach more risk than you really can. And find out where your adviser thinks the risks are.
As Robert Colby, chief legal officer at the Financial Industry Regulatory Authority, puts it: “When I talk to friends I often say, ‘Ask your broker what risks they think they’re having you take on in the recommendations they’re making for you. How much is it and where are you taking it?'”
Better yet, ask your broker to fill out the same risk-tolerance questionnaire and explain his answers. Insist that he create a written “investment policy statement,” documenting what will be in your portfolio and why.
This way, you both might learn something—before it’s too late.
Source: The Wall Street Journal