Risk tolerance: How to measure it and what it really means

If you’ve taken advice from a financial adviser or you read the financial papers, you’ll hear something talked about, which is called risk tolerance.

It’s the illusion in the practice of financial advice that there is each investor within their psychological makeup and they’ve got a fixed quantity of something called risk tolerance.

This is a topic I have covered on The Retirement Café podcast recently – you can listen here.

What really is risk tolerance?

Now, risk tolerance would have to be the percentage decline in the value of someone’s portfolio, the investor’s portfolio, which they could not financially or psychologically or both bear.

The problem is that none of these assumptions which support the quantity theory of risk tolerance is true. Therefore, pandering to the illusion of risk tolerance, allowing it to become a critical variable in the discussions with our clients, sets everyone up to fail probably at the worst possible moment.

Flawed assumptions in the theory of risk tolerance

There are a number of flawed assumptions implicit in the concept of this thing called risk tolerance.

One: Risk is synonymous with price decline. There is only one risk.

This is not true.

There are at least two risks: principle and to purchasing power. And in the act of mitigating either one of these risks, we increase our exposure to the other.

So if I construct a portfolio with the goal of limiting its potential for price decline, IE how much the thing can fall, I’m going to limit this to the same extent the opportunity for the price going up. That’s to say I’m going to compress the potential return.

The more I reduce the potential return, the more I expose it to the erosion of purchasing power. Because obviously, you know, inflation continually erodes the value of your money.

I point out to people again and again that if we’ve got inflation running at 2% and you’re getting 1% on your building society account, then in 12 months’ time you’ve got 99 pounds, you’ve got a real purchasing devaluation of that money.

Well you know that’s huge and if you keep doing that year on year, there is a huge risk to your capital that it’s going to go down in value.

There’s a real risk of loss of purchasing power.

So, what do we do? What do we do and how do we work it out?

One of the really important variables in this assessment of risk tolerance is percentage decline. I don’t agree with this as well.

Since the end of World War II, the stock market has declined about 30% one year in five. And to someone who would need to withdraw significant capital, say in two years’ time, this presents a vastly greater risk than it does to someone with no capital needs for 10 years.

And it may be argued to the person who never plans to take any capital, but to just live on the income and the dividend stream coming from the capital, it represents no risk at all. And since the risk of holding equities declines very sharply over lengthening holding periods, then

it is time which becomes the critical measurements of risk rather than some arbitrary preset percentage price decline.

Time as the risk factor

Another way of looking at this is to distinguish again with time as the real variable between risk and volatility.

To a 55 year old couple whose investments must provide their income for 30 years or more, a 30% price decline is an incidence of volatility but not of real risk.

Now the other thing people believe about risk tolerance is that it’s fixed and once you understand that it isn’t, you know, someone completes a risk assessment questionnaire then that’s it from there onwards.

I disagree.

I think people’s risk tolerance changes continually depending upon the noise in the market. If you think that the world’s going to hell in a handcart, then you’re going to feel much more scared about investing your money in the markets than if you think the economies of the world are booming.

The smart move when prices decline

Actually if you are the Warren Buffett of this world you would probably be buying the shares when everyone else is selling.

Now for every price decline IE, the temporary volatility of the market, there are other people out there buying those shares or equities at that moment in time.

So when you’re thinking of selling, also think about the person who’s buying. When prices are plummeting, as I say, we should be considering increasing our risk tolerance to capture the value, but most investors will be running for the hills.

The unconscious influence and how we advisers can help our clients

At any given moment, an investor’s own estimates of his or her risk tolerance will usually be an unconscious call on the current market and therefore it’s worse than useless.

It just remains an uncomfortable fact of life in these times that our compliance departments and regulators want us to get some kind of handle on just how much tolerance for market ambiguity our clients can muster.

But it’s incumbent on us as advisers to be adult enough to see this effort for what it is and attempt to put our firms in a position where they can’t be successfully sued for failing to gauge just how much adversity a client could take.

So filling out essentially silly forms in order to quantify a willow-the-wisp-like risk tolerance just isn’t the way to do it. Rather, the answer is work with people who understand and explain to them how the markets work and keep them from getting surprised.

The best approach to managing risk and volatility

Advisers just grow up to the point where we understand that market declines are temporary, but there is a permanent advancement and if you’re planning on a 20 to 30 year time horizon for your retirement, then get into the markets, have enough cash to cover those short term needs and just stay invested in a world diversified global portfolio and keep your costs and taxes as low as you can.

And that pretty much is probably the best advice I can give you for those people who don’t actually sit with me and whose portfolios I don’t manage. That’s the message that I’d like you to take out into the world when you’re reviewing your own portfolios or sitting with your own advisers.