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By Jason Stipp and Christine Benz | 08-08-2012 01:00 PM

Rethinking Risk Tolerance

Beyond their ability to stomach short-term volatility, investors should define their risk tolerance in terms of their actual risk capacity and the probability of hitting their retirement goals, says Morningstar's Christine Benz.

Jason Stipp: I'm Jason Stipp for Morningstar.

Recent volatility over the last few months--and over the last few years, really--has put a special emphasis on investors' so-called "risk tolerance."

But Morningstar's Christine Benz, director of personal finance, says there are pitfalls to relying solely on risk tolerance to guide your portfolio decisions. She's here to offer some tips on that.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: "Risk tolerance" is a phrase that comes up quite often when you're talking about portfolio planning or putting a portfolio together. There are risk tolerance questionnaires that people fill out. What are they trying to get at with risk tolerance, and what are some of the shortfalls there?

Benz: Well, usually when you see risk tolerance questionnaires, what they are trying to get at is an investor's ability to withstand short-term losses, or oftentimes it's stated in terms of, can you sleep at night with this level of losses? So, people are asked to look at losses of certain magnitudes and see if that's something they have a comfort level with.

So usually when you hear about risk tolerance, it's framed in terms of your psychic ability to handle a certain level of loss.

Stipp: So, it's kind of a tolerance for the volatility of the market that we may see in shorter time periods--especially swings down, I think, is how they are defining that risk tolerance.

Benz: They are, and you asked, Jason, about the pitfalls of focusing too much on risk tolerance, and when you think about it, the big pitfall is that you're essentially letting your gut drive part of your decision-making, and there's been this whole field of behavioral finance that has cropped up with very valuable research about how investors oftentimes undermine their own investment results by letting their guts do the driving.

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