Your True Risk Profile: Should You Be Investing at All?

Venn_0000_0001.svg_The US equity markets have continued to climb steadily since their abysmal lows of early 2009, so much so that it seems to be making some people nervous (then again, some folks are just perpetually nervous and others make money off creating anxiety). Posts abound voicing expectations at the very least of a correction if not a serious downturn soon. Downturn ahead or no, when it comes to investing you should ask yourself a couple of questions before you go diving down the rabbit hole one more time (or for the first time): How well do I know myself? Should I even be investing at all? Before selecting a fund, before determining your asset allocation, before putting even one cent on the table, you owe it to yourself to have a frank conversation with yourself about…well…yourself. Specifically, you owe it to yourself to assess your true risk profile. Getting a handle on this could be one of the most important activities you ever undertake as a current or would-be investor. The bottom line? Taking a risk-attitude questionnaire is not enough.

Perhaps you’ve heard of these risk-attitude questionnaires or have even taken one already. Maybe a financial advisor gave you one to complete or you were directed to one on some web site. Indeed, these so-called risk-attitude questionnaires abound online. Vanguard has one, so does Schwab, so does the Index Fund Advisors group, so do other firms. Their purpose, more or less, is to ascertain where you stand with respect to risk when it comes to investing (if this sounds vague, then good, you’re paying attention). Other key words and phrases bandied about when discussing the purpose of these questionnaires include assessing “attitude to risk” or “willingness to take risk”.

Vanguard’s current online questionnaire for personal investors consists of eleven multiple-choice questions and a twelfth fill-in-the-boxes type question where you enter your current asset allocation. Included in a currently available version are questions about when you plan to sell your investments and begin using those funds, how many years you equate with the words “long-term investment”, what course of action you would take or have taken with investments that are down, how you would react or have reacted to market declines, how readily you stomach losses, how easily swayed you might be by the investment opinions of non-professionals, the stability of your income sources, your investment experience level, and so on.

After submitting your responses, you are shown your current allocation that you provided in question twelve and a new suggested allocation. I took the questionnaire and was suggested an 80/20 portfolio of percentage of stocks and bonds, respectively, after estimating that I currently have a 60/40 portfolio of short-term reserves (cash, in my case) and stocks (no bonds), respectively. Easy-peasy, rock on with my bad self, ain’t no thang. Time to drop some dough.

Hmmm, wait, I think I just heard the sound of a record scratching to a halt. Is that it? Well, all too often for many, many years, yes, that might have been it. The next step might have been to begin discussions with your advisor on where to place your funds, or, if you were not working with an advisor, to set about the process yourself.

But what have I learned from taking the questionnaire? Am I any wiser about how I really feel about risk, my capacity for risk, why I would even accept risk, or how to actually define and understand risk? Have I even answered the questions honestly or have I instead responded with how I think I should respond? If I’ve never even experienced any hairy investment situations or market fluctuations, how can I know how I would react to or feel about them? If I’ve never been to war, how can I know what type of soldier I would make?

The answers to the questions above are probably “not much”, “no”, “who knows”, and “no idea”. The truth is that today, the industry of investment professionals is coming around to the reality that a questionnaire or any single risk assessment tool is not enough and never was – it’s not enough for you to understand more about yourself vis-a-vís investment risk, and it’s not enough for any investment professional to understand you with respect to investment risk.

In a publication copyrighted in 2012 and directed at investment professionals in the UK, Vanguard UK urges financial advisors to search out their clients’ true risk profiles prior to getting them into any investments whatsoever. Leaning on guidance from the Financial Services Authority (FSA), the regulator of all financial services in Great Britain, Vanguard UK lays out the three pillars of a true risk profile:

  1. “Willingness” to take risk, as evidenced by a risk attitude questionnaire or tool, for example.
  2. “Ability” to take risk, i.e. high net-worth individuals with longer investment time horizons have more ability to take on investment risk as compared with someone who has few assets or will look to liquidate their investments sooner rather than later in order to use that money.
  3. “Need” to take risk, as in I need to send my kid to school in two years so I need to grow my money, and fast.

As you can see, there is much more to consider above and beyond one’s willingness to take risk as evidenced by a questionnaire. The publication stresses that a questionnaire or other tool is to serve only as the bare-minimum starting point for an in-depth assessment of a client’s true risk profile. And these are just the three pillars of establishing such a profile. Vanguard UK goes on to mention a host of other considerations, including contradictions within a client’s risk profile across the three pillars or even within a single questionnaire given that individual’s responses and how those contradictions might be handled, different risk profiles within couples who jointly manage their investments, and the same individual having multiple risk profiles depending on the pool of assets in question (e.g. I’m willing to take more risk with this disposable income here than I am with the money in this account that’s intended for the purchase of my first house).

What we can walk away with, then, is that assessing one’s true stance as regards risk takes more than a questionnaire. It can be a complicated and involved process, as it should be, and completing that process prior to any investing is vital if you ever hope to comprehend the world of investing and your place in it. Why? Well, for one, it may keep you from getting in over your head somewhere down the road. And that can be priceless.

Certainly this does not mean that the questionnaires are useless, but they represent only one component of what should be a well-rounded undertaking and should be collectively considered more a warm-up than the end game for assessing one’s true risk profile prior to investing. What’s especially interesting is that they may serve not only as a starting point for assessing a true risk profile, but indeed as an ending point as well where it comes to the decision to invest in asset classes other than “the safest savings vehicles”. According to the publication, the “pre-screening” built into Vanguard UK’s risk-assessment tool made available only to advisors defaults to a “savings only” result if the following things are true about the client:

  1. They are unwilling to sustain any investment losses.
  2. Their investment time horizon is less than three years.

Yes, if the above pertain to the client, the tool essentially returns a “do not invest in the markets” outcome. Now ask yourself, does the above pertain to you?

In the end, the takeaways from the process will vary across individuals. For you, the process may never go beyond a questionnaire. And on the questionnaire, the most important points may not be about your tolerance for losses or how you would react to downward movements in your investments or broader markets, but rather about whether you would invest in the markets at all if there was a possibility that you would lose some of your money forever. While that sounds extreme, your answer is worth pondering. If the answer in the end is, “Yes, I’m willing to take that risk”, then roll up your sleeves and get cracking because the process of knowing yourself when it comes to risk doesn’t stop with your answers to some questionnaire. There’s much more to the process than that. Embrace it.

{An earlier version of this article was first published on <www.lazytraders.com/insights/>}

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