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Personal Finance Warning: Risk-profile questionnaire ahead. Proceed with caution

Risk profile questionnaires are ubiquitous with investment transactions in Canada, but they've come under heavy criticism in some quarters. Do we put too much stock into them? Or are they just not good enough?

It would be hard to meet with an investor today who hasn't completed a risk profile questionnaire. But given how often investors switch gears with their investment strategies, largely because of their inability to stomach risk, it would seem that the questionnaires are ineffective.

President of the Investor Education Fund Tom Hamza notes that there are two levels of risk that they see, "Actual investment risk, and the risk that comes from not knowing about what you are investing in. Actual investment risk is magnified if you [don't understand]the basics of the products that you are investing in. We see a lot of people magnify the first risk with the second because they haven't taken the time to understand their investments."

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Anecdotally, financially advisers note that sometimes investors answer the 10 to 15 questions as if they were taking a test. They try to select the answers they think a successful investor would select as opposed to what they really feel. For example, a staple question would ask what degree of loss in a given year you could tolerate before feeling uncomfortable, providing a range of possible responses, from "no losses" to moderate double-digit-percentage losses. Some might be inclined to select the highest degree of loss because they've just heard some compelling statistics about the virtues of holding tight through the bad times and the tradeoff between risk and potential return. Being comfortable with risk in a portfolio for an aggressive investor when you are actually a conservative investor is a tall order.

Simply acknowledging that many of these questionnaires are completed in under 5 minutes should be enough of a clue that they aren't sufficient for making long term investment decisions. Some can be completed in under 60 seconds. These assessments, at best, should be used as one of many different tools when assessing risk tolerance of an investor.

Imagine filling in a 5 minute questionnaire about a prospective spouse as the sole decision making criteria for spending a life together. Sure, we all have boxes that need to be ticked off when it comes to what we are or are not looking for, but there's obviously much more to it.

The next time you are presented with a risk profile questionnaire, it should be accompanied by a lengthy discussion about risk. Otherwise, the results are worth the time you put into it: little.

Preet Banerjee, B.Sc, FMA, DMS, FCSI, is a W Network Money Expert, and blogs at wheredoesallmymoneygo.com. You can also follow him on twitter at @PreetBanerjee

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