Correctly identifying an investor’s risk tolerance is critical for productive investing over the long-term. The limits identified by a given tolerance for risk can typically establish, in advance, the maximum downside in investment value that an investor can sustain before their financial objectives become compromised, their decision making becomes emotionally influenced, or their investment process is otherwise adversely affected.
Considering the foundational investment theory that investments with more risk should possess a higher expected return to compensate for the associated risks, establishing an appropriate risk tolerance can also govern the range of returns expected for given investment strategy.
Ultimately, the highest benefit of a thoughtfully established risk tolerance might be a matter of managing expectations. When an investor experiences something that they anticipated, even if it is unpleasant, they are more likely to stick with an investment strategy than if they become rattled by events that reside outside the bounds of expectation.
As important as it is that an investment strategy match the risk tolerance, and that the risk tolerance match the investor, many seem to forget – or ignore – that the process of assessing an investor’s tolerance for risk is multifaceted. Risk tolerance is influenced by both an investor’s ability to tolerate risk, as well as – and often more so – their willingness to tolerate risk.
An investor’s ability to tolerate risk is where many professional advisors get hung up. One’s ability to assume or tolerate investment risk is quantitative. It’s based on factors like present and future income need versus present and future expenses, amount of income in excess of expenses, rate of saving, net worth, investment time horizon, and specified financial objectives, among other quantifiable facts and figures.
Typically, a greater ability to tolerate risk is associated with longer investment time horizons, recurring incomes in excess of expenses, and larger quantities of assets and/or anticipated assets in excess of expected present and future needs. These circumstances are associated with the ability to tolerate risk because they are thought to contribute to relative insulation from the effects of various degrees of investment risk on an investor’s overall financial condition.
Due to the previously mentioned idea that greater investment risks can accompany greater potential returns, professional advisors sometimes fall victim to an insistence that, because one is quantifiably able to assume investment risk, they should undertake as much investment risk as their circumstances permit.
For some investors, assuming as much investment risk as they are able will be the right call. For others, it’s entirely inappropriate
The assessment of an investor’s willingness to tolerate risk is almost entirely qualitative. Really, the evaluation of one’s willingness to assume risk can be further divided into the explicitly stated and implicitly communicated.
Investors will often complete a risk tolerance questionnaire to aid in the assessment of risk tolerance. There are countless varieties of these surveys floating around, but a common format involves a series of questions that attempt to establish a relative measurement of investor sentiment towards risk taking. While the actual questions may range from blunt to ambiguous, the goal is to try to determine how an investor has felt about risk in the past, feels about investment risk presently, and how they might respond to the effects of risk in the future.
Although sometimes difficult for one to assess of themselves, when working with an advisor, the advisor might also factor in clues about an investor’s willingness to accept degrees of investment risk gleaned from previous conversations or aspects of the investor’s life that might affect the way they perceive investment risk. This is the implicit component of the evaluation.
The amount of investment risk that an investor is willing to tolerate is an essential consideration. It is often little more than a matter of an investor’s intrinsic psychology. Yes, one’s willingness to assume risk can often be shaped to some degree by education. However, what an investor identifies as the risks they should or shouldn’t take because of what they’ve learned can sometimes be very different than how they feel when risks materialize. Feelings have a tendency to supersede knowledge under stress.
It would be great if an investor’s ability to tolerate risk always coincided with their willingness to tolerate risk. Occasionally this happens. Frequently this does not.
What happens when an investor’s ability and willingness to tolerate risk are incompatible?
Generally, if an investor’s ability to tolerate risk is greater than their willingness, willingness wins out, and the overall risk tolerance is adjusted down. As mentioned before, education is a powerful tool to help an investor understand how investment risk might be utilized to their benefit. For some, though, education only goes so far, and it is better to yield to an investor’s comparatively low willingness to assume risk than to expose them to a situation in which emotional decisions could eventually result in real financial harm.
If an investor’s ability to tolerate risk is less than their willingness, depending on the magnitude of disparity, caution might be required. An investor with a higher tolerance for risk, who is not financially capable of withstanding the potential effects of the risks undertaken, has the capacity to cause serious harm to themselves. This can be true even under less-than severe circumstances. As with the previous example, education is an important tool of moderation.
Investors and their advisors only considering whether they are willing or able to tolerate various degrees of investment risk are almost certainly missing the mark on risk tolerance. This can expose an investor to future frustration, or worse. When evaluating an investor’s willingness and ability to tolerate investment risk, each factor must be assessed in the context of the other to develop a thoughtful and, hopefully, more appropriate investor risk tolerance.