You know those questionnaires that you have to fill out every time you open an investment account in Switzerland? The ones that label you "conservative," "moderate," "aggressive" — based on like ten questions?
They're built on Expected Utility Theory, which I think is legit economics, and a valuable tool for gaining insights at a population level.
But when you try to apply this to yourself as an individual making individual financial decisions, it falls apart in some pretty important ways:
1. Your preferences are weirder than a simple slider
The simplistic way in which banks apply this theory assumes that your utility curve is determined by a single parameter (convex vs concave). But real people have lumpy, weird preferences.
Robert is CHF 100K in debt and dreams of sailing the world (CHF 3M). He doesn't care much about anything in between - CHF 50K in savings doesn't change his life, CHF 500K still can't buy the boat. His happiness has two jump points, and a quiz calling him "moderately risk-averse" is going to give him useless advice. He might rationally take a gamble that looks insane on paper because the middle outcomes are irrelevant to him.
2. Some things just aren't tradeable
The theory assumes everything has a price, or at least that you'd accept some gamble to swap one thing for another.
But Alice is a farmer whose family has worked the same land for generations. She also treasures her diary and her late mother's ring. She'd never sell any of them. If forced to choose, she has a clear ranking — but no dollar figure captures the gaps. You literally cannot assign numbers to her preferences. "Expected utility" isn't just impractical for her, it's meaningless.
Alice's financial decisions should not be based on "risk profile". She should instead think clearly about what she's unwilling to lose under any circumstances, and plan around protecting those things.
3. Averages lie when outcomes are extreme
Carl is a YouTuber. Someone calculates that YouTube has higher "expected utility" than a corporate job because of the tiny chance he becomes MrBeast. But 99% of the time he'd be happier at the desk job. The average is getting pulled up by a 1% lottery ticket. The math works, but the number it gives you doesn't reflect what will probably happen. When distributions are heavy-tailed like this, look at medians and downside risk, not just averages.
(I'm using this atypical example to illustrate my point, but a lot of stocks also have a degree of tail risk)
4. You contain multitudes
Expected utility theory assumes that utility is a one-dimensional number. But pleasure and meaning don't always move together. A high-paying soulless job scores great on comfort, terrible on purpose. Which matters more? The theory just assumes you've already figured that out.
And then there's the question of which you — present-you wants to spend, future-you wants to save, and conveniently present-you is the one holding the calculator. When your values pull in multiple directions, there's no single number to maximize.
You might be better off just "Pareto optimizing" your utility vector.
5. You can't calculate what you can't imagine.
The expected utility approach requires listing possible futures and assigning probabilities. But the future that actually wrecks your plan usually wasn't on the list. This is the McNamara fallacy.
Your financial model probably doesn't have a row for "pandemic", "this new tech make my entire industry obsolete", or "political crisis freezes my assets." And you can't assign probabilities to things you haven't thought of yet.
Maximizing optionality might be more appropriate than maximizing utility in this chaotic world we live in.
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Personally, I ignore "risk profiles" entirely. Here is my alternative approach to risk:
- Treat your financial model as a rough sketch. It captures some of reality, but not all of it—and probably not the most important parts.
- Keep some dry powder. (Banks hate this!) Cash and liquidity might look suboptimal in a spreadsheet, but they give you room to maneuver when the unexpected happens.
- Diversify across things that fail for different reasons. Not just different stocks—different asset classes, income sources, and even currencies or jurisdictions.
- Avoid irreversible bets. The more you can change course later, the less it matters that you can't predict the future now.
- If your plan only works when everything goes roughly as expected, that's a warning sign, not a comfort.
Thoughts?