User:Dcgdeakin

Risk Tolerance
“Risk tolerance” is a term in common usage, but there is no generally accepted definition. Rather it’s one of those everyday concepts about which each of us has a slightly different understanding. Asked to define risk tolerance, advisers will say things like:

“It’s the level of volatility an investor can tolerate.”

“It is where someone feels comfortable on the risk/return continuum.”

“It is the amount of loss someone will risk incurring.”

While these statements relate to risk tolerance, they do not capture its meaning comprehensively.

A client’s risk tolerance is relevant to an adviser in two general sets of circumstances: first, when the client is faced with a decision and, second, when the client is in a situation that involves risk. Decision making always involves choosing between alternative courses of action. There is risk in any course of action where the outcome is uncertain. Depending on the situation, the possible outcomes for the alternative courses of action may be all favorable, all unfavorable, or a mix of both. Thus,

❑ in some situations the choice will be between courses of action that have only favorable outcomes—a greater good choice;

❑ in other situations the choice will be between courses of action that have only unfavorable outcomes—a lesser evil choice; and

❑ in the balance, the choice will be between courses of action that collectively present a mix of both favorable and unfavorable outcomes.

Accordingly, risk tolerance can be defined as the extent to which a person chooses to risk experiencing a less-favorable outcome in the pursuit of a more-favorable outcome. With this definition, risk tolerance represents a trade-off on the continuum from minimizing unfavorable outcomes to maximizing favorable outcomes, not just an upper limit on unfavorable outcomes. “Risk preference” would perhaps be a better label for the attribute being described. “Tolerance” implies that risk is an undiluted negative. However, most people accept the universal truth of “Nothing ventured, nothing gained.” It’s simply a question of where each individual is comfortable with setting the balance point.

Broadly, risk tolerance can be seen as the sum of all the fear/greed trade-offs—between making the most of opportunities and securing financial well-being, between avoiding regret over losses incurred from taking too much risk and avoiding regret over gains missed through not taking enough risk, and so on. This definition was arrived at through consideration of decision making. Does it apply in the second general set of circumstances, when the client is in a situation that involves risk? In risky situations, the threshold consideration is whether the client is discomforted by the level of risk being experienced because it’s greater than her risk tolerance. If not, there is no issue. If so, then this is actually a decision point, in that the client is faced with the choice between continuing in the situation and trying to remove herself from it, and so the definition works here, too.

Of course, risk tolerance could be defined to mean something else entirely, and sometimes it is. But it would still be important for advisers to understand the value-expressive attribute being discussed here, namely, the extent to which their clients choose to risk experiencing a less favorable outcome in the pursuit of a more favorable outcome.

In fact, it’s not sufficient to define risk tolerance in isolation without considering where it fits in relation to other constructs involving risk, and this is an area of much semantic/conceptual confusion. Some of the confusion has arisen because until recently there was no robust, objective technique for measuring risk tolerance. Accepted wisdom about the characteristics of risk tolerance was largely sourced from the personal opinions of individual advisers, based on their subjective observations of their clients. The lack of a robust, objective measurement technique meant that individual observations were unreliable and no large studies could be done. Some of the previously accepted wisdom now needs to be discarded. (Davey, 2004)

The Differences
Though risk and risk tolerance are both complex issues, some of the complexity arises from the semantic/conceptual confusion mentioned previously and some from erroneous beliefs. Two common semantic/ conceptual confusions are: First, risk tolerance is sometimes confused with “loss tolerance.” How somebody feels about taking risk in choosing between alternative courses of action—risk tolerance—is one thing. How somebody feels if a loss actually occurs—loss tolerance—is another. Risk tolerance is relevant to how someone makes decisions. Loss tolerance is relevant to how someone reacts to an event.

An assessment of risk tolerance is not a prediction of loss tolerance. How a client will react to an unfavorable outcome, loss tolerance, is not predictable with any certainty. A critical factor will be whether or not the outcome was within the client’s range of expectations. Did the client actually understand the risk being taken? If not, the client will likely be much more upset than if they had.

Although nobody enjoys an unfavorable outcome, there’s a significant difference between being unhappy with the outcome and being unhappy with the decision that lead to the outcome. You may choose to have a birthday party outdoors. If the weather is bad you won’t be happy, but you won’t necessarily regret the decision and you may or may not make the same decision for next year’s birthday.

It is likely, though by no means certain, that clients’ reactions to an unfavorable outcome will be consistent with what they said about the level of risk they were willing to take. The better clients know themselves and the more financially experienced they are, the more consistent the reactions are likely to be. In the event of unfavorable outcomes, if proper process was followed, the adviser will be able to take clients back to what they said at the time the decision was made and to show them step-by-step how they decided on the course of action they followed. This may make them feel better—or it may not. But it will demonstrate that they have no cause for complaint about the advice that led to the decision.

Second, risk tolerance is sometimes confused with “risk capacity.” Risk capacity is the amount of money a client could afford to lose without putting the achievement of financial goals at risk. Risk capacity, which more accurately should be called “loss capacity,” is an objective financial calculation. It represents an absolute, downside constraint on strategy selection, which must be taken account of, but it’s not the same thing as risk tolerance.

Risk tolerance has been the subject of numerous research studies. Not all studies agree on all points. Those points on which a majority, if not all, agree include:

❑ Risk tolerance is a personality trait—that is, a distinguishable, relatively enduring way in which one individual varies from another. Test/retest studies have shown consistency over periods of 30 to 120 days.

❑ There’s evidence of four different categories of risk tolerance: social, ethical, physical, and financial. Individuals behave consistently within category but not across categories. For example, hang gliding will correlate with mountain climbing but not with public speaking.

❑ As with many human attributes, risk tolerance is distributed normally. Its occurrence in a population is as would be expected statistically.

❑ A number of correlations between risk tolerance and demographic characteristics have been established

❑ The cause of differences in risk tolerance from one person to another is not settled. As with many personality traits, risk tolerance is thought to be infl uenced by both nature (genetics) and nurture (life experience).

❑ There is no evidence of subfactors in financial risk tolerance—that is, there is no evidence of investment risk tolerance, employment risk tolerance, borrowing risk tolerance, or insurance risk tolerance, for example.

❑ Major world and financial market events have been shown to have no significant impact on risk tolerance