Gary Waters/Getty Images
As a financial planner, I've been trained to administer what's called a risk profile questionnaire to new clients to determine how much of their portfolio should be in more volatile assets such as stocks. One of the best such questionnaires I've seen is this seven-question survey from Vanguard. The methodology involves answering questions on how you feel about risk and when you will need your money, with the answers supposedly determining how much risk you should take. As I said, I'm trained to use these — but I don't.
Don't get me wrong, in theory I love the idea that risk tolerance could be quantified by answering some questions that would magically tell you what your asset allocation should be. I'm opposed to using them, however, because reality indicates it can't. For example, the Vanguard survey said I should have 70 percent in stocks, while other surveys I've taken put me as high as 90 percent in stocks. I'm not going to budge from my current portfolio of only 45 percent in stocks. How could the surveys have gotten it so wrong? Here are three reasons.
1. Past behavior is based on past circumstances
I love the question that asked me how I behave in times of market declines. I agree that past behavior is a good predictor of how investors will behave during the next plunge. So I truthfully answered the question knowing that I bought more stocks in late 2008 and early 2009. The problem is that my answer didn't reveal that it was the hardest thing I've ever done in investing — and that was when I was only about 45 percent in stocks. Had I been 70 percent in stocks before the plunge, I would not have had the cash or the courage to rebalance.
2. A person's tolerance for risk doesn't measure their need for risk
I've never seen a questionnaire measure one's need to take risk, by which I mean where the investor stands in relation to financial independence. I'm not a big spender, but it's not important to me that I die the richest person in the graveyard. I personally find that the good thing about being frugal is that I can be rich with less money. I heed the words of financial theorist and author William Bernstein, who says, "When you've won the game, stop playing." I don't take risks I don't need to take, and I recommend the same for my clients.
See also: Why women make better investors
3. A person's willingness to take risk fluctuates
I may have been feeling bulletproof at the time, because I took this survey just when stocks had hit an all-time high. It's easy to feel brave when everything is up. Not so much when stocks plunge. That's the time when we tend to want to run for the hills and load up on cash. Had I taken this survey on March 9, 2009, when stocks bottomed out, I suspect I would have had a much lower appetite for risk. In fact, even professional advisers fall into the trap of taking on risk after markets surge, only to pull risk off the table after a plunge.
While I don't use a risk profile questionnaire to set an investment portfolio allocation, I do ask clients a few questions about risk and then use the answers to start a discussion. That's similar to Vanguard telling me the 70 percent stock allocation from their questionnaire would merely be a starting point for a discussion rather than an absolute recommended asset allocation.
When determining how much risk you should take, first pick a range for the amount you'd be willing to put in risky assets such as stocks. For example, you may say between 40 percent and 50 percent in stocks. Then consider picking a specific number on the lower end of that range, especially if stocks are near an all-time high, to give you an emotional cushion.
Psychologist Daniel Kahneman won a Nobel Prize in economics for his work showing that we get twice as much pain from losing a dollar as pleasure from making a dollar. Should stocks plunge, it will be less hard to buy more stocks if you know you pulled back a bit in selecting how much to put in stocks. Then compare the allocation to how much risk you need to take. If you've already won the game, consider taking some more risk off the table.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.