By Matt McCoy. Guest blogger May 8, 2014

Richard Drew/AP/File

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Let’s take a trip back to 2008.  You have been tossing and turning at night after spending the day watching the stock market decline…again.  As you lie awake, you think to yourself “We’ve spent all of these years saving as much as we could and now it’s starting to disappear!”  You can’t bear to watch any more of your investing value “disappear”, so you decide to do something about it.  The next day, you find yourself completing one of those online risk tolerance questionnaires.  Among the questions it asks you are your age, at what age you plan to retire, and, most importantly, how much loss of principal you can tolerate on your investments.  At this point, your tolerance for loss is pretty small – if not non-existent.  Your answers lead the tool to calculate your risk tolerance as conservative.  If your risk tolerance is conservative, how did you end up in this situation in the first place?  Let’s go back to 2006 – the last time you completed a risk tolerance questionnaire.

It’s late 2006 and you have watched several years of positive stock market returns, not to mention a pretty good year thus far.  All is well and you are feeling pretty good about your investments.  You run through the same questions regarding your age, retirement and tolerance for investment losses.  Only this time, your feelings  regarding investment losses are starkly different: you feel as though you could comfortably tolerate a loss of 20%.  Your answers lead the tool to calculate your risk tolerance as aggressive. What gives?

As human beings, we have a tendency to rely heavily on the old adage “what have you done for me lately”.  I’ll admit that choosing the time periods above as an example may be a bit extreme, however I’ll bet this is relatively close to reality.  Why did you choose to take less risk in 2008?  Because the market was in decline and you had experienced losses.  Why did you choose to take more risk in 2006 and 2007?  Because the market had been going up and you saw no reason it wouldn’t continue on that path.  The questionnaires do a great job of getting us to think about how we feel about risk presently. but unfortunately they cannot remove the emotion – or our short term memory.  So how do you reconcile this?

The first step is to understand the difference between tolerance  for risk, ability  to take risk, and need  for risk.  As mentioned above, risk questionnaires will help you determine your tolerance (or willingness to take risk) – assuming you can remove recent emotions – however they cannot determine your ability to take risk or your need for risk with great accuracy.  Let’s take a quick look at the interaction between these three terms.