How to measure risk tolerance is a foundational step in building an investment portfolio.
In investing, there is a fundamental correlation between risk and return: in order to have the possibility of higher returns you must take on additional risk, and if you are not willing to take on additional risk you will have to accept lower potential returns. Markets compensate investors who are willing to bear additional risk by providing them with the potential of higher returns. For investors who are not willing to take on additional risk, the “price” they pay for safety is the lost opportunity for higher returns.
It can be very difficult, however, to accurately measure an investor’s risk tolerance. For one thing, comfort with risk is a subjective experience while the risk level of a given portfolio is an objective fact; the risk level of a portfolio can be quantifiably measured, but an investor’s risk tolerance cannot. Therefore, translating one into the other is an act of estimation. Moreover, an individual often has an unrealistic estimation of their tolerance for risk.
For these reasons, measuring risk tolerance is as much an art as it is a science. Let me explain.
An Investor’s Willingness to Bear Risk
A quick internet search will find multiple quizzes that one can take to determine their willingness to bear risk. (Here is one example.) They differ in their methodology and their calculations, but they generally ask a series of questions and produce a number, on a scale of one to ten, that represents an investor’s willingness to bear risk: one being a low willingness to bear risk and ten being a high willingness to bear risk.
These questionnaires are helpful (I use them with my clients as a first step) but they can be misleading. First, the questions ask respondents how they would act in certain market conditions. The problem is that how a person thinks they will act is not always how they actually will act.
As a financial advisor, these questionnaires are one factor that I consider when assessing a person’s willingness to bear risk, but there are other factors I consider as well. This is where measuring risk tolerance is a bit of an art.
One thing I consider is the individual’s trading history. Was the individual buying or selling in early 2009, when the stock market plummeted by half? Does the individual trade often in markets that are subject to volatility? Over time, what has been the typical asset allocation?
Through a combination of assessments and conversation, I draw upon my experience of working with investors to estimate a person’s willingness to bear risk. But that is only half of the equation.
An Investor’s Ability to Bear Risk
In addition to an investor’s willingness to bear risk, we must assess an investor’s ability to bear risk.
The goal is to determine how much volatility is appropriate for the portfolio. An investor’s ability to bear risk is driven by their time horizon, liquidity needs, current and future income, and the amount of flexibility in their financial plan.
Investors with a short time horizon have less opportunity to recover from market losses and, as a result, are unable to accept risk. Investors with longer time horizons have more capacity to bear risk since they have more time to let the portfolio recoup from short-term losses.
With respect to liquidity, we look at the amount of cash a person will need to take out of their portfolio vis-a-vis the total size of the portfolio. An investor who will need to take out 3% of their portfolio every year is able to take on more risk than someone who will need to take out 6% of their portfolio every year. An investor with high liquidity needs relative to the size of the portfolio has less ability to absorb short-term losses and generate cash for their required cash demands.
Current and future income is a factor in an investor’s ability to assume risk in the sense that an investor who has a high current and future income can contribute more to a portfolio than can an individual with lower current and future income. The more that one can contribute to a portfolio, the better able they are to recover from short-term losses in that portfolio.
Finally, the amount of flexibility that one has in their financial plan and lifestyle has an impact the ability to bear risk. Basically, the more flexibility the more ability to bear risk. For example, if an investor wants to retire at age 65 but is willing to work until age 70 if necessary, and if the market has a downturn when they turn age 65, they can continue to work until age 70 and allow their portfolio to recover before they begin taking withdrawals from it. An investor who must retire at age 65 would have less ability to bear risk.
The Bottom Line: How To Measure Risk Tolerance
Measuring risk tolerance is as much an art as it is a science. Risk questionnaires are a great place to start, but a professional financial advisor with experience assessing risk can provide a much better estimation of an individual’s risk tolerance.