Here’s a common scenario in financial advisory: you sit down with an advisor, they hand you a risk tolerance questionnaire and ask you to fill it out. Based on your answers, they’ll determine how aggressive or conservative your portfolio should be. Sound familiar? This is standard practice for a lot of advisors, and it’s based on the assumption that clients know their own appetite for risk, that risk tolerance is a stable and measurable thing, and that their job is to match your portfolio to that perceived level of risk.
But what if I told you this process is deeply flawed? If Daniel Kahneman’s groundbreaking work on behavioral finance teaches us anything, it’s that humans are not particularly good at understanding risk—or even making rational decisions about it. Risk tolerance questionnaires? They often serve as a shiny distraction, offering false precision where uncertainty reigns. And, frankly, they’re asking the wrong questions.
The Problem with Risk Tolerance Questionnaires
Let’s start with a simple fact: clients don’t know how to answer risk tolerance questionnaires. Why? Because no one knows how they’ll feel about risk until they’re actually facing it. It’s easy to say you can tolerate a 20% market drop when markets are calm and your portfolio is cruising upward. It’s a whole different story when the market actually falls 20% and your portfolio is bleeding red.
Kahneman’s work shows that human decisions, especially those involving uncertainty, are far from rational. We’re swayed by emotions, influenced by recent events, and prone to shifting our views based on the news of the day. The way you answer a risk tolerance questionnaire today might look very different six months from now if the market takes a nosedive, the economy stumbles, or even if a contentious election is on the horizon.
Risk tolerance isn’t static—it fluctuates with mood, circumstance, and context. And what’s more, people often don’t know their real tolerance for risk until it’s tested in real time.
External Forces Change Your Relationship with Risk
Think about how life events can influence your view of risk. Let’s say your income is steady, your expenses are manageable, and the economy is booming. You might say, “Sure, I can tolerate a bit of market volatility. Bring on an all equity portfolio.” Now fast forward a few years. Maybe your income has become less certain, or you’ve taken on new liabilities like a mortgage or college tuition for your kids. Maybe the market feels less like a rollercoaster and more like a demolition derby, and suddenly that “tolerance for risk” you had a few years ago doesn’t seem quite so comfortable.
Kahneman’s insights about how we evaluate risk over time—constantly adjusting based on what’s happening around us—show that our perception of risk isn’t stable or predictable. It’s influenced by personal expenditures, changes in income, the economy, politics, and any number of external forces. The risk you were willing to accept when the world seemed stable may feel unbearable when uncertainty creeps in from other parts of your life. So why should your financial plan be built around a one-time snapshot of how you feel about risk? “If individuals are rational, there is no need to protect them against their own choices,” says Kahneman.
Advisors Are Asking the Wrong Question
This leads us to a critical point: advisors are asking the wrong question when they ask about risk tolerance. They’re focused on how much volatility you think you can stomach. But is that really the question you should be answering? Clients don’t care about volatility in isolation. What they care about is whether their portfolio will be able to cover their expenses—whether it will fund their life goals and keep them secure through all the uncertainties they’ll face.
Risk tolerance questionnaires frame the conversation in terms of how much market risk a client is comfortable with today, but they fail to consider what really matters: will your portfolio be able to cover your liabilities when you need it to? That’s the real risk you’re managing—not market swings, but life’s inevitable expenses.
Liability-Driven Portfolios: Solving for the Real Risk
This is where a liability-driven investment approach comes into play. Instead of focusing on matching your portfolio to a vague and fluctuating sense of “risk tolerance,” liability-driven portfolios match your investments to your actual liabilities—your expenses, both present and future.
Here’s the beauty of this approach: it makes the conversation about the real question. Instead of asking, “How much risk can you handle in the market?” the question becomes, “What are your financial obligations, and how can we ensure you have the funds to meet them when the time comes?” This shifts the focus from managing volatility to managing certainty—the certainty that your financial plan will help you cover your future expenses, no matter what the market does in the short term.
With a liability-driven portfolio, the emphasis isn’t on beating the market or outperforming a benchmark. It’s about ensuring that the value of your assets aligns with the timing of your expenses. If your goal is to pay for your child’s college education in 10 years, the priority isn’t whether the market fluctuates between now and then. It’s whether you have the funds to pay that tuition bill when it’s due. That’s the real risk—not market volatility, but the risk of not being able to cover your expenses when they arise.
Conclusion: It’s Time to Change the Conversation
Kahneman’s work highlights the flaws in how we think about risk and decision-making. Risk tolerance questionnaires try to offer a neat, quantitative answer to a question that’s fundamentally dynamic and emotional. Worse, they distract from the more important question:
Can your portfolio cover your future liabilities?
It’s time we stop fixating on risk tolerance as if it’s a fixed characteristic, like eye color. Life is too unpredictable, and your relationship with risk will evolve over time. Instead, let’s focus on what really matters—ensuring that your portfolio is built to meet your financial needs, regardless of what the market does. That’s how we manage risk in the real world: by solving for the uncertainty of your future expenses, not by playing a guessing game with your tolerance for market swings. I’m not saying that risk tolerance should be completely ignored, but should be viewed in the context of a client’s entire financial picture.
This perspective not only builds on Kahneman’s insights into human behavior but also connects to our Life-Driven Investing approach. By focusing on covering future liabilities, we better align with what clients actually need, rather than relying on flawed risk-based questionnaires that fail to account for the true uncertainties of life.
John Grubbs, CAIA®, AAMS®
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