How to use a investment risk questionnaire

Risk, purportedly, is linked to reward.  However it is quite possible to create risk in your portfolio without the reward attached to it.  But when we think of ‘risk’ as investors we are often told to complete a form, from simple to complex, and invest based  on that.  This is the tail wagging the dog, and the wrong way to approach your investments.

Risk appetite analysis, whether produced as a number between 1-100, or as a grade such as ‘moderate’, ‘conservative’ or ‘aggressive’ should be used as a secondary tool, to compare what is actually needed, with what you can actually stomach.  Measuring this with an investment risk questionnaire is a helpful thing to do, but it has its place in the broader picture.

Investing should be goal based.  We will have long term and short term goals, and the assets within them should all have their own liquidity horizons.  Buying a house a year from now? That money should avoid the risk of loss as a primary driver, and have as much return on investment as possible while not breaking the primary focus.

Longer term investments should also be goal driven. The key is to simply estimate how much is needed in retirement, deduct out pensions, social security, and other income streams, and then find out how much return is needed for the savings rate you have established.  This is where the risk assessment kicks in:

• Need $Y in savings
• Can save $X annually
• For Y to reach X, a rate of return of Z is needed.
  • Risk Assessment: Chasing Z, can you handle the downside?

This is a great time to start taking tests to see how you feel about things, for example, if you feel comfortable losing 20% of your portfolio, but you want a 8.5% rate of return, you should understand that you might be more likely to lose 40% of your portfolio with this investment strategy, and can plan accordingly.

Risk assessments telling you that you are a ‘moderate’ investor at this point does nothing, but a risk assessment that tells you that you are way over your head in terms of high risk investments, by looking at both your desired outcomes (the risk assessment) and your actual allocations can be a useful tool.

What to do if you are out of whack?

Many people might find themselves out of alignment in terms of their risk appetite and their actual allocation, it is worth looking at things right away when this happens, but it is also worth taking a moment to think about the impact of your actions.  Selling in a knee jerk manner can cause taxable events, and might be worse than not selling, since you are guaranteeing that something happens to your wealth by selling, vs reducing the risk that something happens to it.  Measure twice, cut once, as my favorite reader likes to repeat.

One strategy that could create a fast asset rebalance without taxable impact would be to focus on deleveraging tax advantaged accounts and use them as the ‘anchor’ on your total wealth.  Over time, changes could be softened out to impact both taxable and advantaged accounts, to make them more in tune with one another again.

Investment risk questionnaires are important, but there’s no point in having a conservative investment strategy if your goal requires a higher rate of reward, and often there is no need to have an aggressive strategy if your assets do not require that level of return.  Finding an imbalance between what you ‘need’ from your investments, and how you feel about that opens the door for great conversations, such as how you will meet the goals while maintaining your level of risk tolerance.  You could find yourself changing savings rates, or even deleveraging your risk based on the outcome.

If you are interested in taking a risk assessment, I’m offering one for the readers of the forum here.