Many advisors, investors are off the mark about risk tolerance

The stock market's roller-coaster ride this year and the uncertain global economic outlook have a lot of investors nervous. Not surprisingly, anxious investors often make bad financial decisions, dumping stocks out of fear when the market tumbles, thereby locking in losses.

By understanding risk tolerance and allocating money among asset classes accordingly, investors are often less prone to make impulsive decisions when the market bounces around, as it has this year.

Yet the seemingly simple concept of risk tolerance is widely misunderstood by investors and financial advisors alike, said Tyler Nunnally, U.S. strategist for FinaMetrica, a Sydney, Australia-based firm specializing in risk-tolerance testing.

In basic terms, risk tolerance is the level of comfort that an investor has with taking financial risk. All investments carry risk, and generally speaking, riskier investments produce higher levels of return over time and vice versa.

One of the most common misconceptions about risk tolerance is that it fluctuates based on how an investor feels about what's happening in the market at any given time, said Nunnally.

In fact, an investor's risk tolerance, if properly measured, is essentially fixed, much like certain personality traits, he added.

"Risk perception is a state of mind and can be volatile," said Nunnally. On the other hand, he added, "risk tolerance is an inherent behavioral trait, like introversion or extroversion, and as such it is rather stable over time."

His firm is a purveyor of psychometric risk-tolerance tests used by advisors, financial institutions and do-it-yourself investors.

The tests produce numerical scores that correspond to different risk groups, from least risk-tolerant to most risk-tolerant. Most people, said Nunnally, fall somewhere in the middle.

"The score is mapped to a range of risky assets that the client would be emotionally comfortable with in good times and bad," he said.

Any reliable risk-tolerance questionnaire, added Nunnally, should produce roughly the same results for an investor when taken more than once over a period of time.

"The point of risk-tolerance assessment," he said, "is to make sure that clients are emotionally comfortable with investments in good times and bad so that they avoid the pattern of buying high and selling low and can stick with their financial plans."

But some advisors balk at the idea of relying on risk-tolerance questionnaires to inform asset-allocation decisions.

Rob Brown, chief investment officer of United Capital, says risk-tolerance tests are widely used within the financial services industry, but they generally leave a lot to be desired.

Brown said such tests basically function as a paper trail; in other words, many advisors and brokers administer them so they can demonstrate to regulators that they are making suitable recommendations for individual clients.

Many academics and psychologists, he said, consider risk-assessment testing "a bunch of nonsense."

"When you work with human beings, you understand that risk is a complex, nuanced matter," said Brown, a chartered financial analyst. "It is a dynamic, living phenomenon."

He added, "To characterize it as a one-dimensional, static number ends up doing more harm than good."

According to Brown, the biggest problem with most risk-tolerance tests is that their results are highly correlated to past experiences. Investors who rely on test results to make asset-allocation decisions may be too bullish or bearish for their own good, he said.

For instance, investors who take such tests in the aftermath of a big market correction are likely to come to the conclusion that they have little risk tolerance, said Brown.

That may cause them to build portfolios that are heavily skewed toward low-return fixed-income products, undermining their chances of earning enough to meet their long-term financial needs, he said.

With many risk-assessment tests, "you are looking backward for a forward-looking purpose," Brown said.

"It's like driving down an L.A. freeway always looking in the rear-view mirror. There is only one outcome, and it's not a good one," he said.

The better course, said Brown, is to work with an advisor to develop an investment strategy that reflects long-term goals, such as the kind of lifestyle you desire in retirement or plans for charitable giving.

By doing so, investors may be more willing to take advantage of market downturns to buy stocks when the herd is selling, if they see that as an opportunity to get closer to their financial goals, said Brown.

"You are doing the exact opposite of what a tolerance questionnaire would have you do," and that might prove to be a good move, he added.

According to Pete Dixon, a partner and advisor at Waypoint Wealth Management, risk-tolerance tests can be a useful tool for investors who want to begin to explore the concept of risk.

Waypoint, a fee-only firm, doesn't use such tests with its clients. Instead, the firm focuses on clients' willingness, ability and need to take risk to achieve financial goals, said Dixon, a certified financial planner.

If, for instance, a client is willing to endure a 50 percent drop in portfolio value in the short term, he or she may be comfortable with an all-stock portfolio, said Dixon.

Clients' ability to take risk, added Dixon, has a lot to do with their investment time horizon. The longer the time horizon, the more opportunity investors have to recover from the inevitable market downturns.

A little education about the basics of investing, he added, goes a long way toward helping clients understand the concept of risk and stick with an investment strategy.

"You don't need a Ph.D. in finance to understand how the markets can benefit you and how they can hurt you," he said.

— By Anna Robaton, special to CNBC.com