Understanding Risk—Capacity, Tolerance, Perception & Risk Required
When it comes to investing, it is important to understand the concept of risk. Consider the following questions in the context of your investment portfolio:
How much risk do you need to take in order to satisfy your goals?
How much risk can you financially afford to take?
How much risk can you emotionally tolerate?
How much risk are you currently taking?
There are many “risk tolerance” questionnaires that attempt to provide insight into answers to these questions and uncover a person’s risk profile. Unfortunately, we have found that, with great regularity, clients misunderstand or misinterpret the questions posed by these formal documents.
So, how is it possible to make effective investment decisions without having a clear picture of a person’s risk profile? We believe you need to have an understanding of a person’s risk capacity, risk required, risk tolerance and risk perception. Let’s consider these four aspects of a person’s risk profile and their significance when it comes to structuring an investment portfolio.
Risk Capacity
Risk Capacity is an investor’s financial ability to sustain risk. Risk capacity has to do with measurable or predictable factors such as an investor’s asset base, savings rates, withdrawal requirements, job and income security as well as time horizon.
Example: Warren Buffet has an exceedingly high risk capacity. He could lose a large portion of his net worth and still be able to satisfy his lifetime spending needs. Warren Buffet’s risk capacity is influenced both by his asset base, spending requirements and his age/life expectancy.
Risk Required
Risk Required is a measure of how much risk a person needs to take in order to obtain a satisfactory return to achieve their financial goals. Like risk capacity, risk required can be calculated and is dependent on asset base and spending needs.
There are certain times when the risk required is unreasonable or unrealistic. Normally, when this is discovered, there are usually a number of trade-off decisions that should be made. Decisions like delaying retirement, spending less or working part-time in retirement would be considered.
Risk Capacity and Risk Required are both elements of your risk profile that can be measured, calculated and monitored with time. As an investment advisor to our clients, we spend quite a bit of time on this component of our clients’ risk profiles.
Risk Tolerance
Risk Tolerance has to do with an individual investor’s attitude towards risk. Risk tolerance involves how individuals respond emotionally or behaviorally towards risk. There are a number of questionnaires that attempt to uncover risk tolerance by asking how you might respond, or feel in certain situations.
Our experience has shown us that when it comes to a person’s emotional ability to tolerate risk, there are many external factors (some of which change on a daily basis) that impact risk tolerance. A person’s life experiences, upbringing, and knowledge level all influence their willingness to accept financial risk, but there are also many other factors. In fact, there have been many research studies that have discovered a number of factors that can impact a person’s willingness to accept risk. Here are a few of the more notable:
A person’s current mood (happy, sad, anxious, angry, etc.)
The amount of money people had between the ages of 18 and 25
When the person ate their last meal
How much a person weighs, if they smoke, or if they recently consumed a sugary drink
The current weather, or time of year
A person’s country of origin or culture
From an advisor’s perspective, it is nearly impossible to predict a person’s risk tolerance from a simple questionnaire. We believe you don’t truly understand a person’s ability to accept risk until you have experienced their response during certain life events or periods of transition.
Recognizing how a client responds to things like a job loss, death of a spouse, market declines, or a serious illness all provide insight into a person’s risk tolerance. Observing client behavior during these periods provides us, the advisor, with a great understanding of how to effectively advise and communicate with our clients. Having a history of working with a client is the only true method of understanding their risk tolerance!
Risk Perception – Your portfolio is not the Dow, or the S&P 500!
I was introduced to the concept of “risk perception” pretty early in my career. It was late October in 1997 and I had been working in the industry full-time for about a year and a half when the “Asian flu” occurred. For those of you who remember this period of time, it was scary. International financial markets were experiencing major structural issues that were impacting the U.S. markets as well. In fact, on one particular day during this crisis, the stock market declined by about 7%.
During this period of uncertainty, one of my clients called to discuss her portfolio. She had heard on the news that the Dow Jones Industrial Average had declined substantially and she was worried that her portfolio would never recover. As I looked through her account at her holdings, I realized that, as a conservative investor, she only owned FDIC insured bank CDs. Her account value had not been impacted a bit by the decline in stocks – she did not own any stocks!
This particular client did not understand how her portfolio was invested and was extremely worried. She had a perception of risk that was not accurate and it was upsetting her. As an advisor, one of the worst feelings is knowing that your clients are worried about their finances. This experience taught me that many people do not understand how much risk they are taking in their investment portfolio. It also reminded me of the importance of educating clients and helping them understand their portfolio – how they are invested and why. Doing so often gives the client a peace of mind during rocky economic periods, personal life transitions, or other tumultuous circumstances in their lives.
It is our hope that embedded into our culture at Beacon Financial Strategies is a mindset of education - teaching our clients about all elements of financial planning and investments. We believe this approach creates an element of partnership that is very productive when striving to reach a common goal – your financial success.