If you have an investment account at a brokerage firm, chances are you’ve encountered a risk tolerance questionnaire.  Such a document purports to determine how comfortable you are with investment risk.  Questions range from the simple – “Are you investing primarily for income or for growth?” – to the sublime – “If you are offered $100 or the chance to win either $0 or $300, which would you choose?”  Such questionnaires are used by the firms to help their salespeople sell you suitable investments and also as protection should the firm be audited by its regulator.  The problem: these questionnaires pretty much tell us nothing about your true risk tolerance.

Daniel Kahneman and Amos Tversky were among the pioneers of what is currently called behavioral finance, which attempts to understand the psychology behind the behavior of investors and ultimately how that behavior affects the capital markets.  One of their most fundamental findings – for which Kahneman was awarded the Nobel Prize in Economics in 2002 – was that people’s attitudes toward risks concerning gains may be quite different from their attitudes toward risks concerning losses.  For example, in answer to the gambling question above, risk-averse people will typically choose the $100.  However, when confronted with the inverse choice of losing $100 or the chance to lose $0 or $300, the same people will commonly select the risky option ($0 or -$300).

This asymmetrical attitude towards risk is also often influenced by the prevailing economic environment.  In early 2009 one of my clients had become so risk-averse that she was ready to sell all her investments.  Of course I spent time with her explaining the value of sticking to her financial plan and investment strategy.  By 2010 – after her portfolio had rebounded not only from market action but from some tactical allocations to a couple of highly undervalued asset classes – she had become so risk-indifferent as to ask what could be done to get her portfolio to outperform that of her neighbor.

In practice, I’ve found that risk tolerance should really be considered in two contexts: (1) your need for risk and (2) your ability to stomach risk.  The first has to do with your financial plan and how much you need to grow your savings in order to have enough money to support everything you want to do for the rest of your life.  The higher the needed growth, the greater the risk you will need to take with your investments (and consequently the greater the potential of having to give up some of your goals).  The second involves your emotional ability to deal with losses.  If you are fortunate, the two are aligned.  That is, your financial situation is such that you don’t need to take on any more risk with your investments than you can handle should markets drop.  Your financial life can become stressful, however, when the two are out of sync.  There are many people who keep all their savings in bank CDs.  Clearly they are risk-averse in the emotional sense.  But they may be taking on way too much risk of achieving their future goals given the potential ravages inflation can impose on a long retirement-lifetime portfolio.

In the end, I’m convinced that a financial plan will help you not only balance the two risk tolerance components but also act as an emotional anchor when times get tough (like in 2008).  Knowing that you have a plan and maintaining the discipline to follow it can help you avoid making the kinds of risky, dysfunctional investment decisions that we as human beings are all to prone to do.