Limited Time Offer: Save 10% on all 2021 and 2022 Premium Study Packages with promo code: BLOG10    Select your Premium Package »

Financial Risk Tolerance

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; 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 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. In a well-funded pension plan, for instance, 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.


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


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.

Featured Study with Us
CFA® Exam and FRM® Exam Prep Platform offered by AnalystPrep

Study Platform

Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Online Tutoring
    Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

    Video Lessons

    Sergio Torrico
    Sergio Torrico
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.