Measuring your ability to handle the ups and downs of stocks is hardly an exact science. But the work of some smart researchers can help you stay calm when the market is freaking out.
By George Mannes, Money Magazine senior writer
(Money Magazine) -- Wise investing isn't simply about your brain power; you also need a sense of how strong your stomach is -- of how much market turbulence you can take before you sell in a panic.
And many of us are fairly clueless about what our tolerance for pain really is. Exhibit A: The $32 billion Americans pulled out of stock mutual funds as the market hit its March low and started a 50% comeback.
So how do you arrive at a better sense of what you can handle? Unfortunately, the tool most advisers, mutual fund companies, and 401(k) plans use to judge your comfort with a roller-coaster market -- the so-called risk tolerance questionnaire -- doesn't do a very good job: It's typically too brief to deliver much insight and mixes up separate issues, such as your time horizon, with your appetite for risk.
Part of the problem, argues John Grable, a professor of financial planning at Kansas State University, is that advisers view the questionnaire less as a way to measure your daring and more as a way to cover their derrières in case your investments go bad. ("This form you filled out in 2004 indicates you're an aggressive investor.")
Grable is among a small group of academics and financial planners who have worked for years in relative obscurity on building a better risk-o-meter. Now the financial crisis (and resulting volume of angry client e-mail) is raising their profile: 76% of advisers polled by Brinker Capital last November said they needed to reassess how they measure risk tolerance.
Whether or not you work with an adviser, the key insights of Grable and others can help you devise a portfolio that can get you to your goals -- and get you a good night's sleep.
You're more conservative than you believe
The asset-allocation tools you'll find online or that an adviser will employ when working with you routinely recommend stock allocations of 70% or more if you're younger than 55 or so. Target-date retirement funds that are the default investments in most 401(k) plans similarly have high stock concentrations, as do planner recommendations you'll typically see in the pages of Money. That's because, over the long run, stocks return more than bonds, so odds are (notwithstanding the past decade's lousy returns) that a heavier stock allocation will give you more money in the end.
Rational, yes. But some of the best work done in the study of risk tolerance concludes that many people can't handle the swings that come with such big stock weightings. As a result, they'll frequently sell at or near market bottoms.
FinaMetrica, an Australian company that has developed a respected risk questionnaire used more than 250,000 times by financial planners, has found that only 7% of investors can stand to have more than 75% of their total investments in stock, and only 1% can handle more than 87%. "The investment industry tends to encourage people to take on more risk than they're emotionally equipped to handle," says FinaMetrica co-founder Geoff Davey.
FinaMetrica's risk-tolerance test is based on pioneering work by Michael Roszkowski, now a researcher at La Salle University. Investment adviser and Golden Gate University professor Douglas Rice, who surveyed 131 such questionnaires, calls FinaMetrica's the best judge of the psychological aspects of risk.
The company typically charges individuals $30 for its report, but Money readers can get one for free through Nov. 30. (See "How Much Stock Is Too Much?" below for help in interpreting results.)
Taking the test now will give you a useful benchmark some day off in the future when stocks are soaring and you're feeling cocky about your ability to take big bets. As Harold Evensky of the wealth mangement firm Evensky & Katz notes, in good times people think they "have an infinite risk tolerance, and when things are going bad they have zero risk tolerance."
Risk tolerance sets a limit on your stock allocation, not a target.
Risk tolerance isn't about how much risk you ought to take when you invest; it's about how much you can take before you'll crack.
A good questionnaire -- or a planner who's deciphering one -- might conclude that you're emotionally equipped to handle a portfolio that is, say, 70% stocks and 30% bonds. But that isn't necessarily an ideal stock allocation; it's your ceiling.
If you need to put only 50% in stocks to meet your standard of living for retirement -- because you're a steady saver and your needs are simple -- then go with the lower number. "Just because you're comfortable with a risky portfolio doesn't mean you actually need one," says Michael Kitces, director of research at Pinnacle Advisory Group, a wealth management firm in Columbia, Md.
Your capacity for risk is different from your appetite for it
Imagine two investors of similar age and income: One is a tenured English professor who tends to avoid stocks; the other is a software salesman who gets paid on commission and likes to regularly jump in and out of the market.
The latter has more emotional tolerance for financial risk. But it's the professor who has the higher "risk capacity," basically, the amount of money a person can lose without suffering a grievous hit to his present or future standard of living.
A professor whose salary and pension are predictable can afford to take more risk with his investments than a salesman whose job security is low and whose earnings can vary wildly from year to year.
Likewise, two people who hold similar jobs and have similar comfort with risk will have different risk capacities if one is older. A basic lesson, but one ignored at great peril in good times: In 2007, according to Vanguard, 35% of 401(k) participants over 55 had more than 80% of their accounts in stocks.
Comfort with the risk you're taking doesn't mean you'll reach your goal
Just because you're resting easy doesn't mean you have nothing to worry about. An asset allocation that falls within your comfort zone may in fact not be aggressive enough to meet your goals -- retirement with a certain standard of living, say, or enough money to trade up into a larger home.
If you fit into the category of people whose goals outstrip their willingness to take risks -- and FinaMetrica's research suggests that's a lot of us -- your choices are simple, though not easy. You can boost your savings rate, scale back your goals, or combine the two steps.
The possibility of a large shortfall isn't just an issue for the risk-averse. FinaMetrica's Davey points out that unlike conservative investors, enthusiastic risk-takers tend to overestimate the payoff they'll receive.
A tamer portfolio can often get you close to your goals with less downside danger. For example, a T. Rowe Price study found that an investor who started with an 80% stock portfolio at age 50 and shifted to 55% stocks by age 65 did nearly as well as an all-stock investor, with much less chance of suffering big losses.
And David Cordell, professor of finance at the University of Texas at Dallas, points out that risk lovers often don't comprehend how big a gamble they're taking when, for instance, they plow a big chunk of savings into one stock. "It's a sign of their willingness to do something," Cordell says, "not necessarily a sign they know what they're doing."