Thank you for your very thoughtful comment.

It is true that a person’s (or family’s) risk tolerance may change over time. That is why some asset allocation models have an age declining component in the ratio of stock-equity assets to bond-fixed income and cash assets. For example, that is why our VeriPlan lifetime financial planning application for individuals supports five different and user-adjustable lifetime asset allocation models.

Two of these five VeriPlan asset allocation models have an age declining component. (One holds a fixed percentage as cash and lowers the allocation to equities 1% annually, and the other sets a fixed ratio between bonds and cash and then lowers the allocation to equities 1% annually relative to bonds and cash.)

One person’s risk tolerance may vary with age, while another’s does not. Other potential factors are wealth and income, which you mentioned. One person’s relative risk tolerance may react to changes in wealth or income, while another does not.

Other factors are investment knowledge and psychological stability. The transient mood swings that you discuss would tend to indicate high variability in short-term personal risk tolerance. If an individual exhibits these characteristics, then they might be a more accurate indication of a lower general tolerance for investment risk. A major point of any psychologically oriented assessment of risk tolerance concerns whether an investors reactions are likely to be stable over time

It is easier for most people to handle the euphoria that may come with unanticipated market highs and good times. However, even then, an investor without knowledge and without a high tolerance for investment risk may still make mistakes. This has been documented in the behavioral finance literature. Many individual investors fear that a price run-up may indicate a higher likelihood of a price decline, instead of a potential sustained price increase driven by favorable economic fundamentals. Individuals tend to sell too soon and miss the upside. In the process, they also tend to pay higher transactions fees and investment costs.

However, it is in major market declines and crashes that people who genuinely have a lower tolerance for investment risk tend to make their most personally damaging mistakes. They give in to their inherently lower tolerance for investment risk and panic. They sell because they cannot bear the paper loss, even though they may not have needed the funds to meet their current expenses. They worry that their investments for future needs will all be gone.

Relative risk tolerance tends to be a more stable psychological characteristic, and one’s investment portfolio should be aligned with that risk tolerance psychology. Furthermore, individuals tend to do a great deal of harm to themselves by jumping into and out of markets because of fear — whether the cycle is trending upward or downward. The scientific finance literature shows that individuals (and professionals) are not good at timing securities markets. Furthermore, frequent changes to investment portfolios are very costly due to investment costs and taxes.

Those who are interested in learning more should follow the links in my article above to get more information on these subjects.

The Skilled Investor

It’s therefore not simply a case of evaluating your risk tolerance once and setting your asset allocation for all time. Even apart from the above factors affecting your risk tolerance, you may find that your risk tolerance varies day-to-day with your mood. If I’m in a good mood and the market drops more than a few percent in a day I just find the “market crashes!!” headlines amusing, and might look to buy some stocks that I’ve had my eye on while waiting for a correction. On the other hand, if I’m sick or in a bad mood I’ll tend to find the impact of a 5% plunge in the stock market on my net worth less funny, and won’t be in the mood to shop for stock “bargains”.

Finally, I’ve found that risk tolerance questionnaires (even fairly comprehensive ones like that available from FinaMetrica) are only indicative of how you’ll actually react when you have money invested and there’s a big, bad, bear market. It’s a bit like paper trading - the effect of having real money on the line can affect your thought processes and decision making.

Regards
http://enoughwealth.com