Risk Tolerance - The Most Useless Financial Planning Metric

By John H. Robinson, Founder/Financial Planner

For the entirety of my 37 years in the financial advice business, the assessment of each client’s personal risk tolerance has been deemed by the regulatory information mandatory information to be obtained and documented at the start of the advisor-client relationship. 

After the relationship is established FINRA and the SEC each require advisors under their purview to obtain updated client profile information every few years that includes any changes to risk tolerance. 

Most readers of this blog know the drill – You either select from a list of risk parameters, such as “conservative growth” or “moderate income,” or you answer a series of hypothetical questions about how you would react to investment losses, whether you prefer guaranteed returns or potentially higher returns that then pidgeon-hold you into a particular risk paramenter.

“When in doubt, just put “moderate,”” a former branch manager counseled me many moons ago, as it gives the firm the best liability protection.

Some financial advisors have created their own customized risk tolerance questionnaires to help address the vagaries of the task.  There are also software applications available to help advicers more scientifically ascertain each client’s capacity for risk. After answering a dozen or more questions, a computer program produces your personal “risk number.” 

A purpose of this commentary is to explain why risk tolerance is an utterly useless metric in its current form, and to propose a better way to help clients manage the various forms of portfolio risk. 

I begin by introducing the problems with current industry approach.  The first two are widely acknowledged, while the others deserve greater consideration in the public discourse.

Problem #1:  Risk Tolerance Is Ephemeral 

One of the most commonly cited criticisms of risk-tolerance questionnaires is that consumers tend to have a much higher tolerance for risk when financial markets are doing well and lower tolerance when markets are falling.  As I often quip, investors have an unlimited tolerance for upward volatility, but not so much in the other direction.

An investor who completes a risk questionnaire after several years of strong stock-market performance is likely to be more comfortable with risk.  That same investor completing a risk questionnaire in the midst of a severe bear market will likely provide different responses to the same questionnaire. 

This pattern is pretty well-documented in behavioral finance.  This isn’t necessarily irrational behavior. It is human behavior, and it obviously presents a challenge when tasked with assigning risk tolerance as a fixed characteristic of an investor.

Problem #2 Risk Tolerance Is Not Clearly Defined

 This problem is even more fundamental.

What one investor considers conservative, another investor may consider extremely risky.

Ask two investors whether a broadly diversified stock-market index fund is a conservative investment, and you may get two completely different answers.

An investor who has spent decades investing in stocks and understands the historical volatility of equity markets might consider an index fund a relatively conservative way to participate in long-term economic growth.

Another investor might look at the possibility of losing 30% or 40% of their account during a severe bear market and consider an index fund extremely aggressive.  As a practical matter, risk isn’t simply a characteristic of an investment. It is a characteristic of the relationship between the investment and the investor. 

There is also no clear regulatory definition.

Problem #3 Consumers Have Been Taught That Stocks Are Risky and Bonds Are Conservative

For decades, consumers have been taught this as rote.  Read the participant education materials in any 401(k) plan, and you will find stock fund options color-coded in red for risky and volatile and bonds color coded for blue for safe and calm.

It sounds reasonable.  It is also dangerously incomplete. The perception of bonds as stable and conservative was developed upon 40 years of steadily declining interest rates from the highs of the early 1980s to the historic low in 2020. During this four-decade span, there were only four years in which the 10-year treasury index showed total return declines.

Investors today have never endured an secular rising interest rate environment, and as as we saw in 2022, bond funds can be quite volatilte when rates are rising.  For example, the Vanguard Intermiate-Term Bond Index Admiral shares posted a 2022 total return of -13.27%.  For its part, the Long-Term Bond Index Fund Admiral shares was posted a 2022 total return of -27.22%!

I think we can agree that most consumers would not associate those returns with conservative investments.

Similarly, investors have also been taught that they should shift their potfolios from stocks to bonds as retirement approaches to reduce volatility.  Target Retirement Date Funds institutionalized this concept in the early 2000s. 

To illustrate fallacy of this guidance, we again to turn to Vanguard’s index-fund based Target 2025 fund’s 2022 performance of -15.19%.  At that time, the portfolio was comprised of roughly 50% stock index funds and 50% bond index funds.  It is safe to assume that many investors who held that fund and were three years  away from retirement were unpleasantly surprised by that much volatility from a conservative fund allocation.

Problem #4 Risk Aversion Is Entirely Rational in the Absence of Education and Experience

I believe most financial planners would agree that risk aversion is a common consumer behavioral trait.  Many academic research studies have demonstrated that consumers’ revulsion to losses outweighs the pleasure they receive from positive returns.  To illustrate by example, while most consumers would willingly bet one dollar on a coin toss to win $2, when the stakes are raised to $10,000 to win $20,000, most consumers will walk away.

However, applying the concept risk aversion to risk tolerance is missing a large portion of the story. 

Academic research describes risk in terms of volatility, but consumers tend to view risk as the possibility of permanent loss.  For an individual investor with limited investment experience, a 20%-30% decline in an S&P 500 index fund might be perceived as a permanent loss rather than a temporary decline in value, and it might trigger further concern for the possibility of a total loss. Unlike the coin toss example, there should be no risk of total permanent loss in proper portfolio management.  

In this example, the investor’s aversion to loss is not irrational, it is simply born out of a lack of proper investment education. If the investor understood that the index fund represented a capital-weighted investment in the largest companies in the U.S., he might realize that there is no risk of total loss and that temporary declines are not losses.

Here again, the root of the problem is not just a lack of financial literacy  but exposure to financial industry-sponsored misinformation.   Consumers have been trained to believe that stock market declines are to be feared.  When I give 401(k) participant education meetings and the market is down, participants are conditioned to feel pain and loss.  They are reluctant to continue to contribute from their paychecks because of the fear of total loss.  

If they had a better understanding of the investments they own, they might realize that periods of down market volatility represent opportunities to catch up through dollar cost averaging. 

The Solution: Replace Risk Tolerance-Based Guidance With Objectives-Based Investment Recommendations

The financial services industry is mired in the horribly outdated notion that financial advisors should make investment recommendations that are consistent with their clients’ stated risk tolerances. This essay has presented four fatal flaws that make risk tolerance effectively a worthless (or potentially even harmful) metric.  It has also raised awareness that misguided consumer perceptions of risk are not only attributable to financial naivete,  but also to misguided education information presented to them by the investment industry.

This risk-matching edict has likely cost consumers untold billions in lost wealth and led them to lower standards of living in retirement than if they had received more evidence-based investment guidance.  For example, I cannot imagine advising a 35 year-old 401(k) plan participant (or individual investor) to allocate his retirement account to a 60:40 “balanced” or “moderate” risk-based allocation because his responses to a risk tolerance questionnaire labeled him or her as conservative or moderate.

So what is a better way?  Give the investment adviser/financial planner free reign to match investment recommendations with the client’s stated objectives.  Instead of requiring them to divine some thinly supported risk number, require the advicers instead to provide a written basis for the recommendations or, better still, provide supporting literature from high domain authority sources.  In the 401(k) space, the plan reps should have greater authority to advise participants and participant literature should be reformed and modernized.

The best investment plan isn’t the one that matches your risk tolerance.

It is the one that gives you the best reasonable opportunity to accomplish your objectives, while taking only as much risk as necessary, and understanding why you are taking it.

Supporting Literature

Don’t Gamble with Your Risk Tool (Morningstar, 11/3/2025)

Risk Tolerance Questionnaires:  Useful or Pointless? (Advisor Perspectives, 9/18/2024)

How Risk Tolerance Questionnaires Can Steer You Wrong (U.S. News & World Report, 6/24/2017)

Mind the Gap: Inconsistencies Between Subjective and Objective Financial Risk Tolerance. (Journal of Behavioral Finance (2017))

The Sorry State of Risk Tolerance Questionnaires for Financial Advisors (Kitces.com, 9/14/2016)

Are Risk Tolerance Questionnairs a Silly Waste of Time? (Advisor Perspectives, 6/7/2016)

How Much Does Risk Tolerance Change?  (Quarterly Journal of Finance (2012))

Changes in Financial Risk Tolerance, 1983–2001 (Financial Services Review (2004))