Risk Tolerance Only Tells Half The Story

Discussions about risk generally revolve around two questions - and they are often used interchangeably.

Question 1: How much risk can you handle psychologically?

Question 2: How much risk should you take on?

The answer to Question 1 is not always identical to the answer to Question 2, even though some financial advisors act like it is. Question 1 is about risk tolerance; how comfortable we are watching our investment portfolios take a hit. But, just because a financial daredevil wants to take a risk, that doesn't mean he or she should.

That's where Question 2 comes in. Unfortunately, risk tolerance alone is often used as the key factor when determining the asset allocation for a portfolio. This article will show how a blend of three factors should be considered when creating a long-term investment strategy: risk tolerance, the financial capacity for risk and the optimal risk.

Risk Tolerance
Risk tolerance is a measure of your willingness to accept higher risk or volatility in exchange for higher potential returns. Those with high tolerance are aggressive investors, willing to accept losing their capital in search for higher returns. Those with a low tolerance, also called risk averse, are more conservative investors who are more concerned with capital preservation. Neither one is "best".

A risk tolerant investor will pursue higher potential reward investments even when there is a greater potential for a loss. A risk tolerant individual might not sell his stocks in a temporary market correction, while a risk averse person might panic and sell at the wrong time. On the other end, a risk tolerant person could be seek out high-risk investments, even if they add little to his or her portfolio.

Example - Why risk tolerance isn't enough. Randal and Dante both work as store clerks. They earn the same wage and have the same limited career options for the future. They are both 38 years old, so they have identical long-term time horizons, too. Randal has a love for the ponies. His long-term gambling addiction means that he is willing to accept terrible losses, even if they jeopardize his financial stability in the future. Dante, however, is very conservative. He squirrels away his meager earnings and hates spending a penny on anything he doesn't need. Despite having identical financial circumstances, they have dramatically different risk tolerances. A portfolio based solely on Randal's risk tolerance might advocate all sorts of risky ventures, even though he's only a store clerk and can't actually afford heavy losses. Meanwhile, a portfolio based on Dante's risk aversion would likely only invest in the safest government securities. Although the capital would be preserved, he would earn nothing more than the risk-free rate, and his portfolio would barely keep up with inflation. If they invested according to their risk tolerance, the net result would be less than satisfactory for both. In this case, a prudent investment strategy would have fallen somewhere between the two extremes.

Your risk tolerance is a measure of how much risk you can handle, but that is not necessarily the same as the appropriate amount of risk you should take. That brings us to the second risk assessment that should be done.

Capacity to Accept Risk
When applying the concept of risk to investing, there are really two types of risk related attributes that are quite distinct. One is psychological attribute known as risk tolerance which we've already discussed. The other type of risk deals with financial ability or capacity to tolerate risk.

Example - Differences in capacity to tolerate risk. Let's consider the fate of three investors who each see a 50% drop in the value of their portfolios. C. Montgomery Burns - Mr. Burns is over 100 years old and has made billions as a captain of industry and atom smasher. According to Forbes his estimated net worth is $16.8 billion. Homer Simpson - Homer is in his late-30s and works as a safety inspector in Mr. Burns' nuclear plant. He has a family to support and is slowly nearing retirement. We'll be generous and give him a retirement portfolio of $100,000. Bart Simpson - At age 10, Bart is just beginning his investment career. He recently won a court settlement against the Krusty-O cereal company for $500, which is his current net worth. A loss of 50% would drop Mr. Burns down to a paltry $8.4 billion. While Burns would no doubt be incensed at the loss, $8.4 billion is still enough to buy him all the ivory back-scratchers he could ever need. Bart, too, has the capacity to absorb a financial hit of 50%. He has many years to continue saving and investing before he needs to think about retirement. Homer, however, does not have the financial capacity to tolerate risk, even though he might be more than willing to gamble it all away on pumpkin futures or some equally risky investment. He has a family to support and less than two decades left until retirement. A 50% drop in the value of his portfolio would be crippling - Doh!

Financial risk capacity can be measured in many different ways, including time horizon, liquidity, wealth and income. People who have a high liquidity requirement - i.e. they could need access to their money at any time - are constrained to how much risk they can take. They are forced to avoid investments that might be potentially lucrative because they do not offer the required liquidity. Over the long term, volatility of the markets is dampened, and returns will move toward long-term historical averages. The longer the time horizon, the greater the capacity for risk as the short-term volatility of the markets loses its significance.

Those with high income and high wealth can make higher risk investments because they have funds coming in regardless of the market conditions. Similarly young investors, with limited funds to invest, have the capacity for high risk because they have longer time horizons. Any short term drops can be waited out, lowering the chance of having to withdraw before the markets bounce back. This brings us to the third consideration, the optimal risk of the portfolio itself.

<% IF NOT IsViewAll() THEN%><%END IF %>Optimal Risk
Quite different from risk tolerance, and risk capacity, is optimal risk. The previous types apply to the individual investor, but optimal risk applies to the construction of risk-efficient portfolios. Optimal risk of a portfolio comes from modern portfolio theory. Central to the theory is that investors are trying minimize variance (risk) at the same time they try to maximize their returns. (For background reading, check out Modern Portfolio Theory: An Overview.)

In this theory there is a perfect combination of asset classes. This is the point where adding another unit of risk will provide the most marginal return. Putting it another way, it is the point you will get the most bang (return) for your buck (risk). This point is found on the curve of the efficient frontier (Figure 1).

Figure 1: Curve showing the efficient frontier. Optimal portfolios should lie somewhere on this line.

Source: Investopedia.com © 2008

The efficient frontier is determined through an optimization that analyzes various combinations of different asset classes. It is based on historical relationship between risk and return and the correlations between the various asset classes. (For related reading, see Diversification: It's All About (Asset) Class.)

As with any calculation, the information going into the model might be imperfect, which could result in an incorrect result. Also, as it's a historically-based calculation, it will not necessarily hold in the future. There is no guarantee that the optimal mix for the past 10 years will be the same as the optimal mix for the next 10. (For a detailed discussion of optimal risk and the efficient frontier, read Understanding Volatility Measurements.)

How Much Risk Should You Take?
For most investors, their risk tolerance, their financial capacity for risk and the optimal portfolio risk will be aligned closely. In other words, they're close to each other on the efficient frontier. However for some investors the balance is out of alignment.

Often when investors meet with a new financial advisor they will be asked to fill out a risk tolerance questionnaire. There are three problems with this approach:

1. The questions are all hypothetical - In real life investors often act differently than they assume they will act when faced with adversity. Being asked how you'd feel if your portfolio dropped 30% is much different than actually watching it happen.
   
   
2. A risk-tolerance-based portfolio may not meet financial objectives - A portfolio that meets risk tolerance objectives, could fail to meet financial objectives. For example, an risk averse investor might end up with a portfolio that won't eventually be worth enough to support him or her during retirement.
   
   
3. Risk tolerance may not align with financial reality - What you can psychologically tolerate might be greater than your financial capacity to do so. For example, an investor who trades futures can psychologically handle the volatility, but a large bet that goes wrong could wipe him out financially.

First and foremost, the capacity for financial risk should dominate. An investor should never take more risk than he or she has the capacity to absorb. As an example if you needed all your money next week, you would not invest all of it in the stock market today. If your current finances can not handle a temporary set back, then risk should be avoided. Investors should strive for the optimal risk point where there is a good tradeoff between risk and reward. (For help personalizing your risk level, read Determining Risk And The Risk Pyramid.)

Conclusion
When developing a long-term investment strategy and strategic asset mix, there are three types of risk that should be considered: the risk tolerance of the investor, the financial capacity for risk and the optimal risk. Understanding the differences among these three helps investors develop a portfolio with the risk that is most appropriate to their circumstances.

by Ken Hawkins, (Contact Author | Biography)

Ken Hawkins is a financial writer and vice president of Second Opinion Investor Services www.secondopinions.ca, an investment consulting firm that provides unbiased and independent investment advice. His experience spans the investment world of the private client investor as well as the world of the institutional investor representing pension funds, asset management companies, mutual funds and investment counselors.