Many facets to risk tolerance

No one way is right for asset allocation

Your Money


Judging by the multitude of "risk tolerance" or "investor risk profile" questionnaires I have filled out lately, I should invest in a "balanced" portfolio of about 60 percent stocks and 40 percent fixed income.

But there is no way I am going to do that, not now.

Although I am risk-averse, 60 years old and semiretired, the questionnaires steer me toward a stock-dominated portfolio.

That's largely because I tend to hold my investments for the long term and supplement my investment income with freelance writing. The asset allocation of 60 percent stocks and 40 percent fixed income is the one that more closely corresponds to my answers to questions about investment experience, goals and risk-reward trade-offs.

But that's not what my gut tells me, and I am going with my gut. My decision is to keep no more than 30 percent of my portfolio in stocks now (or 40 percent tops, counting real estate and commodities). I sleep soundly at night with this more conservative portfolio and still expect to achieve the return I need to fulfill all my financial goals.

I am not at all suggesting that my asset allocation is appropriate for most people my age, let alone others. There is no one "right" asset allocation, only one that's best suited for you, given your unique circumstances and goals. Rather, I want to make these points:

First, the ubiquitous risk-tolerance questionnaire you see in financial magazines, or receive as part of the sales literature for mutual funds, variable annuities and other investments, is only one tool among many to help determine how much risk to assume.

Second, even if a questionnaire gauges your risk tolerance correctly, you should treat it like a speed-limit sign.

If a questionnaire suggests an 80 percent stock allocation based on your risk tolerance, for example, I would read it as saying you shouldn't have more than 80 percent of your money in stocks, not that you must have 80 percent in them.

"Unfortunately, a lot of the questionnaires are designed to find an estimate of your maximum risk tolerance, which is really to the benefit of Wall Street salespeople," said Richard A. Ferri, a chartered financial analyst and author of the book All About Asset Allocation, published by McGraw-Hill in September. The riskier asset classes, such as stocks, typically come with higher expenses and management fees.

Most people tend to overestimate their risk tolerance. That's why most investors would be better off with an asset allocation below their maximum risk tolerance.

Otherwise, "you are not going to maintain your plan" and will panic and sell at the wrong time, said Ferri, president of Portfolio Solutions LLC, a fee-based investment advisory firm in Troy, Mich. Ferri's firm offers its clients an "asset allocation stress test" that shows, in dollar losses rather than percentages, how a particular asset allocation would have performed during previous down markets.

"I've been in this business almost 20 years, and I find that most people have a risk tolerance that is lower than what they are willing to admit in public or in a risk-tolerance questionnaire," Ferri said. In addition, we often answer the same questionnaire differently at different times in our lives, or after recent good or bad news (a promotion at work or a layoff, for example) or even based on our mood a particular day.

Before we can choose an appropriate asset allocation, we have to at least have an idea of the return we need. If 5 percent a year is enough to meet our goals, it would be foolish to take unnecessary risks (and perhaps incur a big loss) with an aggressive portfolio designed for somebody who needs much higher returns.

Humberto Cruz is a columnist for Tribune Media Services.

Baltimore Sun Articles
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.