Updated Tuesday, July 22, 2014 as of 9:26 AM ET
What's Wrong With Risk Assessments: Willingness vs. Need
Tuesday, May 13, 2014

In the past year or so, Iíve personally taken two risk profile questionnaires. The first, by Vanguard, pegged my stock allocation at 70%, while the second, from Wealthfront, put me at 91% stocks and commodities. In reality, Iím about 45% in risky assets and not about to change.

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.

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(3) Comments
The real problem with risk tolerance questionnaires is that they arbitrarily define "risk" as "market risk" and ignore all other forms of risk that we face as investors. That may work will in a CYA sense for FINRA and for the industry, but does a gross injustice to most investors.

Alan says that "stocks are far riskier than high quality bonds". Really? That is true if you equate "risk" to "market risk", but that slight of hand aside, is that really true. Indeed, while it is unquestionably true that stocks may decline in value, it is hard to imagine that interest rates won't rise over time. In that case, what will happen to the value of those "high quality bonds"?

Alan goes on to invoke the decline in value of stocks during the great depression, but it is worth bearing in mind that in Bill Bengen's famous analysis, it was not the investor who retired in 1949 who funds did not last his lifetime, but the investor who retired in 1968 who was devastated by the inflationary 70s.

Does this mean that we should ignore market risk? Of course not. What it does mean is that we should be wary of minimizing one kind of risk (market risk) in a manor that dramatically increases other forms of risk (inflation risk, interest rate risk, longevity risk, etc.). Sorry Alan, we don't live in a risk free world. While we can seek to manage risks, we can not avoid them.

Posted by David M | Tuesday, May 13 2014 at 2:15PM ET
Excellent distinction between reality and perception by clients, Mr. Roth. Now if you would only acquire some understanding about equity indexed annuities and the ability to be honest about them.
Posted by Gary D | Tuesday, May 13 2014 at 2:25PM ET
Interesting, and the author's experience with risk questionnaires and generic risk assumptions is similar to mine. However, his generalized assessment of which asset classes are considered 'risky' is a bit dated. The bond market has enjoyed some relative stability for 30+ years, but under current market conditions, "stocks are far riskier than high-quality bonds" just doesn't fly right now. Particularly when it comes to bond funds - which is where the majority of moderate-wealth individual investors hold their bonds. My safe (safer) money is deployed assets that are not directly correlated to the stock nor the bond markets. I'm sure I'll return to bonds at some time in the future, but I'll wait until that market stabilizes.
Posted by don g | Wednesday, May 14 2014 at 4:16PM ET
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