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; an investor may have the ability to take on risk but may be extremely risk-averse and unwilling to expose himself to any potential loss.
Ability to Take On Risk
The ability to bear risk is measured typically in terms of time horizon, expected income, and level of wealth relative to obligations. Typically an investor with a longer time horizon has a greater ability to bear risk as 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 its lifestyle even in the event of a portfolio loss has the ability to take on a lot of investment risk. Similarly, 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 and while there is no single agreed-upon method for measuring willingness to take on risk, this may be gauged through discussion with the client and the use of psychometric questionnaires.
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. 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.
In the case of 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 the lower of the ability and willingness to assume risk.
Given the following client scenario, which best describes the ability to take on risk and willingness to take on risk?
The client has a high-paying executive position for 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
The correct answer is B.
The client’s wealth is relatively substantial and exceeds its 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.
Reading 54 LOS 54d:
Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance