“Risk” may be an inherently worrisome word, yet it is a key factor to consider when building a portfolio designed to meet one’s objectives. Our next several blogs will define risk in several of its varied forms, and discuss strategies to address it.
Risk Tolerance vs. Risk Capacity
An initial challenge in addressing risk in a client’s portfolio is the simple fact that “risk” is not very well defined, and it presents itself in several forms.
One of the most commonly used terms is “risk tolerance,” which refers to an investor’s personal -- largely emotional -- views regarding risk. Based on their life experiences, how conservative or liberal are they when it comes to accepting risk in an investment? Obviously, this is quite subjective and can be challenging for an advisor to determine.
The term “risk capacity,” however, is equally important and fairly straightforward to calculate. After considering known factors, such as the client’s financial resources and the client’s goals, we can determine the amount of risk likely to be needed in a portfolio to meet those objectives.
The danger in setting up a portfolio based on risk capacity without due regard to the investor’s risk tolerance is that the investor might abandon the plan at some point – and this usually happens at the worst time from a strategic financial viewpoint.
Stated simply, the better able we advisors are to assess your risk tolerance, the better able we are to provide you with the appropriate advice to help you reach your goals without undue trauma.
The key question is, given that risk tolerance is subjective, how can we accurately assess this factor? In the next blog, we’ll discuss how we approach this issue.