Though risk profile questionnaires are flawed in assuming the way we feel about risk is stable, a much bigger flaw is that they look only at willingness to take risk and ignore our clientís need to take risk.
Clientsí portfolios are stored energy that gives them the freedom to do what they want with their lives. Passing wealth on to heirs is an important goal, but itís not the clientsí primary goal.
Take, for example two 65-year-old clients who each have a $2 million portfolio. The first needs $150,000 annually beyond Social Security to fund his lifestyle, while the second needs only an additional $50,000. They may both have a high willingness to take risk, but the second client has a very low need.
Because stocks are far riskier than high-quality bonds, the second client may need only a small amount of riskier stock assets while the first client has a much greater need for equities. As the advisor and author William Bernstein puts it, the second client has won the game and needs to quit playing.
Because I live fairly frugally, my need to take risk is low and having even 70% risky assets would be too high. There is always a possibility that stocks will decline by 88%, as they did in the Great Depression. The world is a risky place with unrest in the Mideast, Ukraine and North Korea, and terrorism is far from defeated.
So while a stock collapse isnít a prediction, itís certainly a significant possibility. Those with no need for risk in their portfolios -- because they have enough stored energy to meet their needs for the rest of their lives -- shouldnít take the risk. On the other hand, the very wealthy can build a lifestyle portfolio of U.S. government-backed fixed income and invest the rest of the portfolio for future generations.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.
- New Test for Risk Tolerance
- 'Deep' Portfolio Risk: How to Protect Clients
- A Better Way to Determine Clients' Risk Tolerance
- Why Every Client Needs an Investment Policy Statement