What You Don’t Know About Risk Tolerance

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[From FPA Retreat 2010, our on-the-ground reporter highlights one of Thursday’s sessions.]

Geoff Davey, the well-known president of Australian psychometric risk assessment company Finametrica, presented an exploration of what planners might not know about risk tolerance, the topic of the hour in the wake of the financial crisis.  You can download his handout here. His presentation was an in-depth exploration of risk tolerance, from the anecdotally interesting (repeated and careful examination shows no collapse of risk tolerance during the financial crisis) to the systematic  (most risk tolerance questionnaires aren’t adequately measuring risk). Geoff also wrote an article for the Journal of Financial Planning on the topic back in 2005, which you can find here (member login required).

In his presentation, Geoff defined risk tolerance as “the extent to which an individual would normally choose to risk experiencing a less favorable outcome in the pursuit of a more favorable outcome,” based on the definition offered in the ISO standards on financial planning.

Many financial planners explore risk tolerance—how much risk clients prefer to take, others measure risk capacity—the risk clients can afford to take. But Davey made the point that it’s a mistake to let risk tolerance drive the asset allocation. Instead, he advocates measuring risk tolerance, risk capacity and risk required (the risk a client must take to meet his or her goals), but to base asset allocation decisions only on, and only partially on, risk required.

He suggested a three-point plan for incorporating risk assessments into a plan:

  1. Assess risk required, risk capacity and risk tolerance.
  2. Identify mismatches (incompatibilities between partners, incompatibilities between risk assessments [low capacity for risk, high risk required or low risk tolerance, high risk capacity]). Help resolve trade-offs.
  3. Obtain client’s properly informed consent before moving forward.

 Other points:

  • Risk tolerance is a psychological trait, with physical, social, ethical and financial aspects. People’s tolerance tends to be consistent within type, but not across types. The example Davey gave was that a mountain climber is more likely to also hang glide, but not necessarily more likely to be a risky investor.
  • Our understanding of risk tolerance is growing with inputs from the fields of genetics, neuroscience and behavioral finance.
    • Studies of personality models are beginning to see possible correlations with personality traits of openness, agreeability; implications from personalities that exhibit overconfidence or issues with locus of control.

Mary Corbin
Managing Editor, FPA Press; Senior Editor, Journal of Financial Planning
Financial Planning Association
Denver, Colo.

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