Why Risk Tolerance is a Flawed Concept

By James E. Wilson via Iris.xyz

Look up risk tolerance on Google and you will see more than 149,000,000 results. Most of the higher ranked listings are actually investment risk tolerance quizzes. These short quizzes provide the impression that risk tolerance can be precisely determined merely by the answers to a few questions.

In reality, your tolerance for investment risk is mostly governed on the emotional plane and can’t be measured by questions about risk on the rational or intellectual level. In general, trying to quantify risk tolerance with a high degree of specificity is a ruse.

Risk Tolerance is a Flawed Concept

The entire idea that investors have a certain tolerance or “appetite” for risk is flawed. Regardless of how much (or little) “taste” someone has for market fluctuation, if the desired planning outcomes are not achieved, the risk level isn’t appropriate. To me, it’s like asking if someone wants to consume chocolate or broccoli. Ultimately, if it’s the broccoli that generates most of the investment returns, your “appetite” better include a large portion of broccoli or you will likely fail financially.

Moreover, referring to market fluctuation as risk misses the mark. What risk should really mean is not achieving your personal financial goals. Is a 20% allocation to stocks “less risky” than the inverse? Most risk questionnaires would say so, but not if you need the higher returns to reach your goals. In that case, there is more actual “risk” in the portfolio with the lower stock allocation percentage.

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