Let's compare two different people: one wins $1 million in the lottery, the other has an accident and loses the use of his legs. Which one will be happier with their life 12 months after these events? That's easy. The lottery winner, right? In fact, research of actual Illinois State lottery winners and new paraplegics reveals an astonishing result. Members of both groups are equally happy with their lives a year later. Honestly! This wasn't just one quirky bit of research, either. Dozens and dozens of well-designed studies have reached the same conclusion: We don't have a very firm grasp on what truly makes us happy.

In his brilliant and funny best seller Stumbling on Happiness, Harvard psychologist and leading happiness researcher Daniel Gilbert tells us why. He proposes that the unique competence of the human brain is its ability to envision the future: We hurry to an appointment because we imagine the embarrassment or inconvenience if we're late. We stop at a red light because we can imagine the accident or traffic ticket that might otherwise result. We save for retirement because we have imagined what life will be like 20 years from now.

However, he demonstrates in great detail that we repeatedly "mis-predict" the impact that future events will have on our actual experience. The new field of positive psychology or happiness research demonstrates that all of us dramatically and continually misjudge how happy or unhappy we will be in reaction to life events. Humans, Gilbert says, have the ability to "synthesize happiness" in a way almost entirely independent of outer events. We have, in essence, a psychological immune system that modulates our experience enabling us to deal successfully with profound loss and adversity. (If you don't have time for the book, don't miss his terrific 20-minute lecture on the topic at ed.com/talks/lang/eng/dan_gilbert_asks_why_are_we_happy.html).

What does this have to do with financial planning? Well, here at the Kinder Institute of Life Planning we've been thinking recently about the nature of risk tolerance and the way financial advisors seek to measure it as a guide to portfolio construction. Most advisors use some form of questionnaire to document a client's risk profile, so the advisor can guide them to conservative or aggressive investment choices as appropriate. Pretty straightforward stuff.

However, such risk assessment exercises assume that people are capable of correctly imagining a future and ranking how happy they will be under different scenarios. As markets drop, an advisor might inquire, "What would make you feel worse, losing more of your capital or missing out on an upturn?" In so doing, we are asking clients to predict their emotions. The research shows that without exception people are perfectly lousy at doing this.

Financial markets over the last year or two have tested everyone's ideas of risk tolerance. How many investors got skittish and sold despite their earlier declarations about being long-term investors? The thing that typical risk tolerance tools miss is that during violent market swings, humans experience even more violent swings of emotion.

Investors tend to over-predict their expected happiness when markets soar and under-predict their panic when markets sink. The herd rushes in during upswings and stampedes out during downswings. Or in the words of the author and celebrated investment advisor Harold Evensky, "People have infinite risk tolerance when markets are going up, and zero tolerance when they're going down." If that's true, what's the meaning and value of measuring risk tolerance?

The whole subject of "risk" is particularly confusing for advisors and their clients because the word is used to describe two completely different concepts. Financial professionals use the term to refer to the technical measurement of a given asset's variance and correlation with respect to the broader market of investments. But there's nothing technical about a client's experience of risk; it's visceral and emotional, not intellectual.

That's one of the reasons why financial life planning works better than traditional modes of client discovery. Financial life planners are trained to understand and work with the emotion and meaning that inevitably attach to our concepts of money and finances. A financial life planning engagement therefore starts with a rich discussion of what a client finds most meaningful, what goals or aspirations really excite them, what turns them on.

STARTLING RESULTS
We can't know someone's tolerance for risk if we (and they) don't know what they're risking their money for. The kind of deeper discussion that I'm suggesting here takes some additional training to handle well, but it bears tremendous dividends. Life planning concentrates first and foremost on a person's life, not the absolute value of their holdings. That means that discussions with clients tend to focus on how to make progress toward life goals rather than on the relative performance of a portfolio that inevitably fluctuates. And this is in turn a bulwark against hotheaded behavior when markets turn sour.