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Why Risk Tolerance Is Overrated

Financial advisers may focus on fortitude, but ‘risk capacity’ is more important

By Chris Farrell

What’s your risk tolerance?

 

If you ever consulted a financial adviser or signed up for an online investment advisory service, you've no doubt heard that question. And if you suffered through the stock market’s roller coaster ride of the past few years, you’ve probably reconsidered your answer.

By asking about your emotional response to risk, advisers aim to determine how much uncertainty you can withstand when you make an investment. In plain English: Just how would you feel if your investment lost money and how much of a loss could you handle?

 

 

Risk capacity is a measure of how much risk your finances can realistically absorb.

 

Think of it this way: An investment with a strong chance of losing $10,000 over the next year may be daunting. But it's more daunting to a 32-year-old woman with a new family and $30,000 in her 401(k) than it would be to a 60-year-old with $800,000 socked away for retirement whose kids have finished college.

 

“Risk capacity is an objective measure that reflects how much money you can afford to lose, even in a worst case, without impairing your goals,” writes Zvi Bodie and Rachelle Taqqu in Risk Less and Prosper: Your Guide to Safer Investing.

 

 

Instead, you should focus first on the security of your employment income and your career’s financial prospects. To judge how much risk your household can absorb, look at the volatility of your earnings from work, the outlook for your future career income and your odds of becoming unemployed. Together, these three factors are a critical gauge. An understanding of these are what you need to construct an appropriate investment portfolio. 

 

Let’s say your income is relatively stable and secure. If you can be relatively confident of earning a decent income and any spell of unemployment will likely be short, your household can handle more market risk — like a greater exposure to stocks — than someone with a less reliable income. With that in mind, you might invest somewhat heavily in stocks to help pay for retirement or another future dream, knowing that you can depend on your wages even if the market turns on you. 

 

 

The depth of your business network counts, too. These days about half of all job offers — and maybe more — come through informal channels: connections to friends, family and colleagues. So your risk of going a long time without work will be greatly reduced if you have a large, well-connected network.

 

 

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Of course, the risk capacity calculation involves judgment rather than certainty. Life has a way of upending reasonable assumptions about careers; technology is an unpredictable disruptor of industries. Still, thinking through everything from your income to your business networks will give you a sound foundation, one that will help you judge how much financial risk your household can absorb.

 

 

Once you’ve determined your capacity for investment risk, that’s the time to consider your psychological and emotional ease with the kind of portfolio that would suit your risk capacity. This is when you might want to take one of those risk tolerance quizzes. One good one is the Investment Risk Tolerance Quiz devised by personal finance professors Ruth Lytton at Virginia Tech and John Grable at Kansas State University.

 

I confess, however, that I’m not a huge fan of these questionnaires in general. The gap between answering hypothetical, multiple-choice questions on your computer and actually living with the consequences of your investment choices is enormous.

 

To complicate matters further, remember this: Risk tolerance isn’t static. As Peter Bernstein, author of Against the Gods: The Remarkable Story of Risk, wrote: “Few people feel the same about risk every day of their lives. As we grow older, wiser, richer, or poorer, our perception of what risk is and our aversion to taking risk will shift, sometimes in one direction, sometimes in the other.” So if you plan to take a risk tolerance quiz, take it again from time to time in case your risk tolerance changes.

 

 

We’ve lived through a decade marked by two bear markets, two recessions, a global credit crunch, disappointing stock market returns and unexpectedly large bond market gains. You probably learned a lot about your reactions to abrupt changes in market values during that time. If so, use the insight and knowledge you’ve gained to your future benefit.

 

 

What is your sleeping point?

Photograph of Chris Farrell
Chris Farrell is senior economics contributor for American Public Media's Marketplace. An award-winning journalist, he is author
 of the books Purpose and a Paycheck:  Finding Meaning, Money and Happiness in the Second Half of Life and Unretirement: How Baby Boomers Are Changing the Way We Think About Work, Community, and The Good Life. Read More
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