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Market sell-offs: How well can you assess risk?

A currency trader reacts in front of screens showing the Korea Composite Stock Price Index.

Ahn Young-joon/AP

After a steep sell-off, it's valuable to reflect on the standard portfolio risk profile questionnaire, which asks investors anywhere from five to 20 multiple-choice questions in order to ascertain just how much risk they could stomach. They often include a question like this:

"What is the maximum drop in the value of your portfolio that you could handle before you would start to get uncomfortable?"

There is a range of possible answers, from "no loss whatsoever" to "50 per cent or more." All good in theory, except when it comes to practice. Multitudes of investors bail on their portfolios at drops lower than what they said they can handle.

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In that case, how close to reality were the questionnaires?

Personally, I relish market downturns. I've got time on my side. With 30 years until 65, the lower my cost base, the better. And I have also seen many investment portfolios rebound, normally right after an investor bails on them. Many experienced investors feel the same way. It is buy low, sell high after all.

What if, for the less-experienced investor, these simple risk profile questionnaires are doing damage? If they put investors into riskier portfolios than they should be in, they could panic and sell at troughs. That would lock in losses and miss out on subsequent rebounds: the result being buy high, sell low.

An investor who can stick to a moderate risk portfolio versus one who bails on a moderate-aggressive risk portfolio is going to end up with more money at the end of the day.

So, determination of the level of risk in a portfolio is not trivial at all. It can have a huge impact on your net worth over time. Is a simple, multiple-choice questionnaire that can be filled out in less than five minutes good enough? How would you overhaul it?

READERS, I'd like you to weigh this as well: Fees for fund companies, dealers, and advisers are typically higher for equity products than fixed income. How much does the equity allocation, and the associated higher fees generated, weigh in on the level of risk investors have in their portfolios today? (Specifically with respect to conflicts of interest for these three groups?)

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