Financial Risk Tolerance

Financial risk tolerance is made up of two components: the ability to take on risk and the willingness to take on risk. The two may not always be in alignment. While an investor may have the ability to take on risk, they may be extremely risk-averse and unwilling to expose themselves to any potential loss.

Ability to Take on Risk

The ability to bear risk is measured in terms of time horizon, expected income, and level of wealth, relative to obligations. An investor with a longer time horizon has a greater ability to bear risk since there is more scope to recover losses over the time horizon. Similarly, an investor with large wealth relative to its liabilities will typically be able to withstand greater risk. For example, a very wealthy investor who can sustain their lifestyle even in the event of a portfolio loss has the ability to take on a lot of investment risk. Likewise, a pension plan with a large surplus of assets over its liabilities can take on more risk than a plan which has an investment deficit.

Willingness to Take on Risk

Willingness to take on risk has a psychological component. Even though there is no universally accepted method for measuring willingness to take on risk, a discussion with the client and the use of psychometric questionnaires could be useful yardsticks.

Conflict between Ability and Willingness

The willingness to take on risk has to be consistent with the ability to take on risk. There may be instances within an institutional environment where there is a conflict between the willingness and ability to take on risk. For instance, in a well-funded pension plan, the trustees and beneficiaries may wish to adopt a low-risk investment approach while the plan sponsor wants to invest more aggressively. In such a situation, the trustees must always act in the best interests of the beneficiaries.

Further, in case of such a conflict, the advisor should not aim to change the client’s willingness to take on risk, assuming that risk aversion is not due to misinterpretation or miscalculation. The prudent approach is to find a risk tolerance level that is lower than the ability and willingness to assume risk.

Question

Given the following client scenario, which option best describes the ability to take on risk and willingness to take on risk?

The client has a high-paying executive position in a large multi-national company. The client’s lifestyle is relatively conservative, and as a result, the client has accumulated $5 million in savings and has paid off the mortgage over a property. The client will reach retirement age in 15 years. The client believes that “cash is king” and the financial markets are “just a gamble.”

A. Ability: low; Willingness: high.

B. Ability: high; Willingness: low.

C. Ability: low; Willingness: low.

Solution

The correct answer is B.

The client’s wealth is relatively substantial and exceeds their lifestyle requirement and financial obligations. The earnings are expected to continue for 15 years, a fairly long time horizon and as such, the ability to bear risk is high.

However, the client demonstrates a low willingness to take on investment risk perceiving the financial markets to be “a gamble.” Therefore the willingness to take on risk is low.