Wednesday, October 12, 2011

Financial Planning "Rules of Dumb" Part 2

Rule of Dumb 3: It's best to use a 10 question form to determine your Risk Tolerance

Seriously? If it were that easy why not just hire a trained monkey to handle your investments? Determining risk tolerance is a difficult task. Everyone is motivated by Fear and Greed. When the markets are doing well everyone tends to get more aggressive. After the last few years no one has much of a stomach for volatility. The typical Risk Tolerance Questionnaire you fill out from most financial services companies is designed for mainly one purpose. CYA! or should it be CTA. To COVER THEIR ....., well you get the picture. These forms help them minimize lawsuits so they can say "Our recommendations were suitable for the client, we invested their money based on their risk tolerance." Give me a break! Those things are highly unlikely to get anywhere close to your real risk tolerance. Dan Ariely wrote an article for the Harvard Business Review ( where he surveyed people with similar questions from a typical Risk Tolerance Questionnaire. No matter how he asked the questions everyone came in about average.

It is better to dive into past behavior to determine your real risk tolerance. How did you think, act, feel, and react the last time your investments took a big drop? Past behavior is a big indicator on how you will react the next time we see another 2008. Risk Tolerance is purely psychological and different people have different "financial personalities." Some people are Gamblers and some are Misers (and anywhere in between), and these personalities have been developed over many, many years. It takes more than a simple one page questionnaire to figure out what makes someone tick regarding their investments.

Rule of Dumb 4: Asset Allocation Lowers Your Risk

I am a believer of asset allocation if it is done correctly. Most advisors manipulate what asset allocation really is and use it as a sales tool. Example, you get a call (or a knock on your door) from your local investment guy. His company spends alot of money on national advertising so you feel like he is creditable. You meet with him and he does a FREE review of your investments. He comes back with a very fancy report from Morningstar and you are impressed. He goes on to show you how you are not properly diversified by talking about sectors and styles. And if you would have been a client of his and followed his asset allocation model for your investments you would not have lost as much over the last few years. Maybe so but high-in-sight is always 20/20!

Many people are not properly diversified and are taking way too much risk but it is a more complicated issue that cannot be addressed from only a Morningstar Report. There are many asset classes: Stocks, Bonds, Real Estate, Emerging Markets, International, Fixed Income but for your allocation to be correct it must be based on 3 things. What is the return necessary to meet your goals? How does that line up with your tolerance for risk? And what is the functionality of each asset class you own? You can look at styles, sectors, and mutual fund mangers all you want but you will never have the proper asset allocation model until these 3 things are addressed. By addressing these 3 things you lower risk on 2 levels. The risk or volatility of your investments and the risk that you won't meet your goals.

Rule of Dumb 5: You Need a Financial Plan

This one might confuse you since I am a Certified Financial Planner but let me explain. A financial plan is something that you prepare only once before you start investing your money. What people really need is Financial Planning, an ongoing process that assures clients are on track to reach their goals. It is a process NOT an event. You need someone that understands you and your goals. Someone that can hold you accountable and steer you away from making mistakes with your money.

Hopefully this post will make you realize that Financial Planning can be more complex than some try to make it. Everyone's situation is different and using rules of thumb may not work for you. Radio and TV personalities have made themselves very rich by dumbing down financial planning so they could market it to the masses. But don't fall into the trap of believing everything you hear applies to your unique situation. If you have any questions please visit my website at

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