Warren Buffet has some simple rules for investing:
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
If you’ve ever walked into a financial planner’s office or a brokerage firm, chances are you were handed a “risk assessment questionnaire,” or something like it. The purpose of this quiz is to assess how much risk you are comfortable with when it comes to investing.
To determine your risk assessment profile, you’ll proceed to answer questions such as:
“Would you be willing to take risks in order to meet your long-term financial objectives or would you rather protect your principal at the expense of future gains?”
“Would it be acceptable to experience a 30% loss if it was followed by a 30% gain later on?” (We’ll be looking at this question in more detail below).
“Will you need this money in ten, twenty or twenty-five years?”
A computer program will then use this information to assign you a risk tolerance label such as “moderately conservative” or “aggressive.” A chart will then be generated with recommendations to “diversify” your assets into a variety of stocks, bonds and/or mutual funds.
Here are some problems with this all-too-common scenario:
- Only a limited menu of investment options are presented.
If your financial planner presents you with a narrow choice of stocks or bonds, why would you question whether or not these are your only options? Be aware that your “investment representatives” are often salespeople hawking financial products from a large corporation – hardly unbiased advice! The consumer is forced to assume that stocks, bonds and mutual funds are the preferred options, as no other choices are typically offered.
- The client is forced to act based solely on conjecture and speculation (otherwise known as guesswork).
You might have the stomach for extreme sports such as snowboarding or mountain-climbing, but that is not an indicator of how well you can stomach losing your hard-earned money. However, you will be asked to project how you will feel about hypothetical financial scenarios that will drive your investments for decades to come.
- An illusion of security is fostered by risk assessment profiles.
A financial planner making recommendations might predict that a portfolio won’t realize more than a 5 or 10% loss, when a much larger loss is actually feasible.
Even people who have lost 50% of their portfolio value doubt a repeat crash could happen again. The 2008-2009 losses are seen as being a one-time glitch in the system, even though questionable Wall Street practices such as investing in derivatives, CDO’s and other high stakes gambling with other people’s money have either continued or resumed.
Mr. Value Investor himself, Warren Buffet, couldn’t sidestep the economic downturn. In September 2008, Berkshire Hathaway shares had reached a high point of $147,000. By March, 2009, that number had plummeted more than 52% to $70,050. It took five years and two months for this stock to recover and finally surpass its 2008 level.
If the most profitable investor of all time can be caught unaware by a Wall Street crash, how reliable will a questionnaire and a computer algorithm be in keeping your investments safe?
Risk assessment profiles are also used to get us to buy into such financial half-truths, such as:
- You can’t get decent returns through safe investments.
- The only big earners are those willing to embrace aggressive strategies.
- It is business-as-usual to let someone else control your assets until they are needed for retirement.
- It isn’t your financial planner’s job to protect you from losses, it’s only their job to help assess your level of risk tolerance.
Reduce Your Risk AND Raise Your Investment Results!