One of the sillier fictions energizing our compliance departments in recent years has been the notion that our clients have an objectively knowable – and fixed – tolerance for "risk." You can fill out a form, and know your "risk tolerance"…and there it will stay.

Of course, when the word "risk" is used in this context, it never actually means "risk": it means "the amount of downside volatility clients say they will accept, beyond which they will probably panic out and sue us." This is unfortunate, because "risk" actually means "the possibility of permanent loss within my investing time horizon." Thus, if my wife and I have a joint life expectancy of 30 years, there is mathematically/historically no risk to investing our capital overwhelmingly in equities, should we choose to do so, because there has never been a 30-year period in which equities lost principal. It should be clear to you that absolutely no participants in the "risk tolerance" debate are defining "risk" this way.

This spring and summer, we were treated to yet another demonstration that "risk tolerance" is, in reality, not fixed in the least, and therefore never objectively quantifiable or even knowable. "Risk tolerance" – which, in less than half a year, we have all gotten to observe from both sides – is as volatile as is the human nature which governs it.

In the spring, as emerging markets soared and credit spreads narrowed, we were able to observe an almost limitless rise in the investing public’s appetite for risk. The more that the most inherently volatile markets rose, the greater became the investor’s willingness to embrace those markets – to see them, based on recent past performance, as where he should be placing his capital.

Then, in the savage global re-pricing of risk that began in late July, markets turned horrifically volatile. Indeed, the credit markets became not merely dysfunctional but non-functional. Risk tolerance in the institutional debt markets did not simply decline: as short term US Treasury yields fell in a matter of days from 5% to 3%, it disappeared. This was not a money panic, but a credit panic. Credit (see the Latin verb credere, to believe) is ultimately the belief that one will be repaid, along with a pricing of the risk that one won’t. For the better part of a month, there simply was no such belief, and therefore there was no credit.

At the level of our client, the individual investor, there was a concomitant collapse in "risk tolerance." As hedge funds, market neutral funds and the like all blew up, and as the equity market collapsed, retail investors came to accept – virtually overnight – not merely the possibility but the probability of dire, long-lasting consequences impairing the fundamental soundness of the economy. (That the seizing up of the credit markets was essentially a financial event rather than an economic event was lost on the individual investor, who – being an economic illiterate – cannot begin to make this distinction.)

Let us generalize from the foregoing reportage, and see what we may learn.

First, as we have just observed, market movements since the February-March pullback – a virtual meltup, followed without apparent warning by an epic meltdown – prompted a well-nigh schizophrenic cycle of change in "risk tolerance": he who feared nothing on the Fourth of July feared everything by Labor Day. Counseling an individual investor around those two holidays, you might have concluded that you’d spoken to two different people.

The performance maniac who excoriated you in early July for burying him in tortoise funds as hares went whizzing by morphed into the nervous Nellie who wanted to hide his whole net worth in a money market fund a month later – "but only if you think it’s safe enough!" (When the individual investor is even afraid of money market funds, you are somewhere near one of the great bottoms of your whole career. But I digress.)

This illustrates the first of three great truths about "risk tolerance" which I seek to elucidate (from the Latin "to bring out into the light") in this essay. To wit: far from being fixed, immutable, knowable and even quantifiable, "risk tolerance" in the individual investor is every bit as volatile as are all his other emotions – because it is from his emotions, and not his intellect, that his "risk tolerance" is derived at any given moment. Your compliance department may wish to believe – or simply act as if it believes – that "risk tolerance" is fixed. But as Galileo is supposed to have muttered under his breath – after he knuckled under to the ecclesiastical court which had threatened to burn him if he didn’t agree that the sun revolved around a static Earth – "Pero, se muove" ("Nevertheless, it moves").

The second important conclusion we may draw from observing these schizophrenic six months is that people change their "risk tolerance" in reaction to, rather than in anticipation of, market movements. That is, "risk tolerance" is essentially a lagged response. (Forget about what the nature of the response is, for the moment: that’s great truth #3. Just focus on the fact that "risk tolerance" doesn’t change until after the fact.) This is an important realization, because we know that no one can ever become a successful investor in reaction: one succeeds by acting, but one can only fail by reacting. Thus, changing one’s "risk tolerance" in response to market events – again, regardless for the moment of how one is changing it – must be a losing strategy, and a formula for substandard returns.

You’ve already anticipated the third great truth. (Indeed, I had to hold you back from it in the last paragraph, because I want you to see both aspects of this fundamental mistake, and not mush them together.) It is that the individual investor reacts to market movements by altering his "risk tolerance" pro-cyclically rather than countercyclically. That is, as prices rise – and especially as they rise sharply, thus extinguishing value – the investor perceives that risk in those assets/markets is actually declining, when in fact it is rising.

Since price and value are inversely related, risk is highest when prices are highest; the converse is equally true. As value is squeezed out of an asset/market by rising prices – as the fundamental fuel of the price rise is burned up in the ascent – there is less and less substance supporting the advance, and it is in increasing danger of flaming out. Hence, the curve of rising prices is also describing an arc of rising risk.

The individual investor perversely reacts to price movement as a confirmation of value. If a stock goes from 15x earnings to 50x – or if gold goes from $250 an ounce to $700, or oil from $20 to $80 – he will see it both as more attractive and (this is crucial) less "risky." He will make similar judgments about whole asset classes and markets; finally, he will extrapolate these pro-cyclical reactions into a view of the economy itself. The U.S. equity market was never, in my adult lifetime, perceived to have lower risk than it was in the second half of 1999. The top-performing equity fund in the world in 1997 – which attracted massive net inflows in the first half of 1998 – was a Russia fund…just before that country defaulted on its sovereign debt, and its currency went into free-fall.

And the converse. The complementary manias for real estate and hedge funds – as allegedly high-return, low-risk asset classes – were a phenomenon not just of excessive liquidity but of a massive psychological revulsion against mainstream equities on the part of the individual investor. That is, his "risk tolerance," in 2002 and beyond, dictated an epic, pro-cyclical response to a decline which produced the greatest stock market bottom in 70 years. One could go on and on, but why bother?

It is just this emotionally driven, reactive, pro-cyclical alteration in the public’s "risk tolerance" that advisors are dealing with today – and will go on dealing with, as long as they encounter the one thing in life that is truly immutable. And that, of course, is human nature. You can no more create a form that can stop the endless cycle of "risk tolerance" than you can change human nature, stop time, or make the sun go around the Earth.

Have some sympathy for the compliance cops. They spend their professional lives trying to build files, while we are out here in the real world, trying with all our might to build relationships. Our job may be hard, but theirs is impossible, because they’re trying to institutionalize a way of calibrating human behavior that can never work – based, as it is, on assumptions that can never be true.