How Will You React To Risk?

One of a financial planner’s common tools is a “risk tolerance” questionnaire. If you have ever answered questions such as, “If the market went down xx%, and your portfolio declined by $xxx, would you sell?” then you might have taken one of these self-assessments.

The idea behind risk tolerance is to ask for a panic point – at what level of risk (measured in terms of volatility, but practically speaking, what we really mean is “loss”)  will the client insist on selling? If you mis-forecast how you will react, and your financial planner designs your plan accordingly, you could either suffer needless losses, or miss opportunities for better returns.

The problem is, most of us are not very good at predicting our emotions, nor behavior based on those emotions, in advance. This is called a “self-assessment gap.”

The latest market volatility has brought this question front-and-center once again. When the market isn’t bouncing around, we may not give much thought to the risk we thought we could handle.

Measuring Risk Tolerance Gaps

In the 2nd quarter 2017 Journal of Behavioral Finance, Italian professors Nicoletta Marinelli,  Camilla Mazzoli, and Fabrizio Palmucci sought to find factors that lead to self-assessment gaps most often, and how often we underestimate and overestimate our real ability to handle volatility (losses).

In the study, having “cautious economic behavior” – owning a home, being a heavy saver, and having less debt – increases the chance of correct self-assessment. Somewhat surprisingly, having high income, and being married, lead to more self-assessment errors. (The authors make a couple of educated guesses about the reasons for this. High income people might be less concerned about risk, and not as careful in their assessments. Married people might be reflecting the combined risk attitude of the couple rather than their individual assessments.)

It should come as no surprise, however, that there was a clear connection between financial literacy and accurate self-assessments. Since April is National Financial Literacy Month, it struck me as one more way in which low financial literacy can unknowingly and unnecessarily cost a lot of money.

Help With Assessment Accuracy

Being financially literate doesn’t mean understanding all the technical details of finance. As the study shows, though, it would be a good beginning to have a clear understanding of yourself. Rather than taking a 10-question quiz, ask your trusted financial professional for a more in-depth meeting about who you are, what risk means to you, and your history when it comes to money.

For more on risk tolerance and typical money behavioral mistakes, see Chapters 6 and 7 of The Mindful Money Mentality: How To Find Balance in Your Financial Future. ​

 

Holly Donaldson

Holly Donaldson, CFP® has an advice-only, hourly and fee-for-service financial planning practice. She is the author of The Mindful Money Mentality: How to Find Balance in Your Financial Future (Porchview Publishing, 2013) and publisher of the award-winning monthly e-letter, "The View From the Porch." With a fully virtual practice in Seminole, Florida, Holly primarily serves clients located in the Tampa, St. Petersburg, and Clearwater areas. Holly will also work with clients who are a good fit located elsewhere in the United States except Texas.

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