These profile questionnaires are supposedly developed by psychologists, and are designed to predict how you will behave in certain circumstances. Theoretically, if you panic and sell anytime the market loses 10 percent, you have a low risk tolerance and should be invested mainly in high quality fixed income funds.
The following is a question I took from an actual questionnaire.
How do you react to unexpected bad financial news?There are at least a couple of issues with this question. First of all, this is a self assessment, and as such draws on the idealized vision we have of ourselves that we take to first dates and job interviews. Who likes to think of himself as someone who always overreacts? Or if they did know it, would be willing to admit it? Do you know someone who overreacts yet remains in a state of denial?
- Always overreact
- Frequently overreact
- Rarely overreact
- Almost never overreact
- Never overreact
The second issue with this question is that investors have very short memories. We are already forgetting the pain of the 2008 market plunge and beginning again to see ourselves as risk takers. Sure, we may have sold half of our stocks in October, but that wasn't overreaction, was it? Personally, I sure think selling after a plunge is the wrong thing to do, but the investor answering this question might not think so and may choose to only remember that he held the other half.
Our feelings about risk are unstable
I ask people a question: "What would you do if the value of your stock portfolio fell be 50%?" The vast majority answer that they would buy more stocks. Of course buying low and selling high makes sense to the logical part of our brain, as noted by Jason Zweig, author of Your Money and Your Brain. Zweig calls the logical side of our brain the reflective brain and our emotional side our reflexive brain.
After people answer that of course they would buy more stocks after the half off sale, I point out that I have asked only a theoretical question. To better simulate how they would actually feel, I would have to ask that question while simultaneously kicking them in the stomach so that their reflexive brain could engage. Certainly last March, when the market hit bottom, many investors felt like they had been kicked in the gut.
As it happens, risk tolerance is anything but stable. Money represents security and freedom. And when we watch our balances decline we are also seeing our ability to pursue our future dreams declining along with them. Fear and greed ebb and flow much like the ocean waves.
During the five years ending in 2007, we enjoyed some very unusual, yet consistent, stock gains where our U.S. stocks nearly doubled and our international stocks nearly tripled. Research shows that we tend to believe we have a much higher risk tolerance in good times such as during those five years.
During down years, research also shows that fear takes over and our attitude on taking risk drops dramatically. In bear markets, we find ourselves much less willing to take risks than we might have thought, which causes us to buy stocks during the good times and sell during the bad. That is why, on average, an investor pays a 1.5 percent annual penalty for poor market timing.
My advice on risk
My advice is never to rely on a risk profile questionnaire to tell you how much you should have in the market. In good times, try to pick an allocation a bit more conservative than you might feel. In bad times, try to push yourself to take a little more risk. Once you pick the allocation, however, stick to it. A consistent portfolio of 50 percent stocks and 50 percent fixed income will almost always, in the long-run, outperform a portfolio that averages 50 percent in each but moves into and out of the market.