During bull markets when optimism reigns, the responses will indicate a high appetite for risk and stocks; during bear markets, the responses will reveal a low appetite for risk and stocks.
When an investor opens an account at a branch of an investment firm, they are often asked to complete a risk-assessment questionnaire in order to determine their asset allocation. If the questionnaire indicates a high tolerance for risk, the adviser will recommend a high proportion of stocks relative to bonds. Vice versa, a low tolerance gets them a low allocation to stocks. This is a flawed approach.
That's because attitudes toward risk are a subjective matter, more affected by emotion than logic. During bull markets when optimism reigns, the responses will indicate a high appetite for risk and stocks; during bear markets, the responses will reveal a low appetite for risk and stocks. When the market subsequently cycles to a different sentiment phase, many of the assessed investors become uncomfortable with their asset allocations.
At this point, advisors will urge clients to stick with their previously expressed preferences, implying the problem lies with clients' lack of discipline. But it may have more to do with the risk-assessment method and its underlying assumption that the right asset mix is the one with the highest percentage of stocks an investor can live with.
I believe Warren MacKenzie, founder of Weigh House Investor Services and author of The Unbiased Advisor (2007), has it right. He says investors don't necessarily need equity exposure as high as risk questionnaires prescribe during optimistic times. If the return required to reach the desired level of capital is calculated, they may find that a lower equity weighting suffices.
"A risk-tolerance questionnaire may protect the brokerage firm, but it's not the best way for you to determine the level of risk you should be taking in your investment portfolio," Mr. MacKenzie advises. "A wise investor takes no more risk than is necessary to achieve his or her goals."
READER: Does more a willingness to risk more equal more stocks in your portfolio?