Three fatal flaws of risk-profile questionnaires

(MoneyWatch) While surfing the Internet, I came across an advertisement by Vanguard to help me determine how much risk I should take. I answered the seven-question profile in less than 30 seconds and got an almost instantaneous response that recommended I should be 70 percent in stocks and 30 percent in bonds. Actually, I'm about 42 percent stocks and 58 percent fixed income. Should I get more aggressive?

Though this Vanguard risk-profile survey is one of the best I've seen, in my opinion. it has three flaws. Before reading on, I suggest you take the one-minute survey.

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Flaw 1: Willingness to take risk may vary, but the survey sees it as stable. One statement aimed at assessing risk tolerance read:

Generally, I prefer an investment with little or no fluctuation in value, and I'm willing to accept a lower return on this investment.

There is a fair amount of research that shows investors view taking risk much as they do applying sunscreen; it depends on the weather. If the weather is fair and sunny, bring it on, but when storm clouds creep over the horizon, forget about it. I took this questionnaire at a time when the stock market was near an all-time high. Had I taken it in March of 2009, however, I'm not so sure I would have answered the questions in the same way.

Flaw 2: Ability to rebalance is impacted by one's target allocation. One of the statements read:

During market declines, I tend to sell portions of my riskier assets and invest the money in safer assets.

I answered this question truthfully, stating that I strongly disagreed. It suggests a proclivity to jump ship in response to market fluctuations, which I see as the path to long-term underperformance. Rebalancing back to one's asset allocation is the way to go, though it isn't necessarily easy. I ought to know, having walked my talk and rebalanced during the scary market plunge of 2008 and 2009. I'd be the first one to admit that doing so required a whole lot of bullet biting and antacids.

And it was hard even though I had less than half of my assets in stocks. There is no doubt in my mind that if I had been 70 percent in stocks, I wouldn't have had the courage to risk the little bit I had in fixed income. Daniel Kahneman won the Nobel prize in economics for his work in prospect theory, which posits we get far more pain from losing a dollar than we get pleasure from making one. Because rebalancing is so critical, I tend to work with my clients to set a more conservative allocation, one they'll stick with, rather than a more aggressive allocation they won't.

Flaw 3: Failure to analyze the need to take risk. There can be no cookie-cutter approach to taking risk when there are so many factors determining how much is appropriate, such as age, assets and financial goals. Personally, I now have little need to take risk, thanks to living fairly frugally, saving and investing with focus and discipline. To me that means as long as the U.S. government survives, I can support the desired lifestyle for my family. But there was nothing in the survey that asked about my need to take risk.

Vanguard responds

I spoke with Francis Kinniry, CFA and principal at Vanguard's Investment Strategy Group, about the survey. Kinniry feels that willingness to take risk is to some degree stable after two market plunges over the past 14 years, and that now is a good time for investors to assess their willingness to take it. Kinniry believes that since extra-return (market-risk-premium) stocks are likely to outperform bonds, taking more risk is warranted, and that inflation is a risk if the portfolio is too conservative. He also points out that consumer inflation is higher than the consumer price index. Kinniry feels that questions about the time to invest (number of years before the money is needed) help assess risk better and that, even at a modest 2 percent withdrawal strategy, the more aggressive 70 percent equity strategy would be the safer bet, according to Vanguard's model.

My take

Though Kinniry's points are well thought out, I disagree with them. To take into consideration time to invest would be helpful if we were mathematical beings with no emotions, but it is emotions that drive us to time the market poorly. And I don't need an economic model to show me that stocks can fall 88 percent, as they did during the Great Depression. Whatever the cause of such a decline, be it a war in the Mideast, a terrorist event or something I haven't thought of, I wouldn't want to be 70 percent in stocks if any of these scenarios were to take place.

Still, Kinniry and I agree on several points. First, the questionnaire was a starting point on the allocation decision, not a standalone answer. Second, sticking to one's allocation is more important than getting it right in the first place. Finally, the broad, low-cost funds recommended in the survey are generally the funds I most recommend.