Helen Yang, CFA, August 09, 2021
An investor risk profile is crucial in wealth management, encompassing risk tolerance, risk capacity, and risk composure.
Inspired by the work of Michael Kitces and Dr. Daniel Crosby, I am proposing a 4D risk framework to capture all aspects of an investor’s risk profile. It encompasses:
- Risk tolerance
- Risk capacity
- Risk perception
- Risk composure
It starts with risk tolerance, i.e., how much risk you want to take. Then risk capacity comes into play. This is not any different from when you buy a car or a house. You start with what you want and adjust based on what you can afford.
Risk perception and composure are fundamentally different because perceived high risk doesn’t automatically translate to poor behavior.
Is Risk Tolerance Stable?
Many advisors report that their risk tolerance assessments are not stable if a client takes it multiple times. It is due to the limitation of the tools they use. Self-described risk tolerance may indeed be unstable because it tends to be influenced by the mood of the client. In addition, some risk tolerance tests can be confusing, making the results unreliable.
Based on my experience, the results from properly constructed risk tolerance assessments are stable. But as time changes, the client’s risk tolerance can evolve over time.
Kitces shares this belief. Furthermore, he believes that it is the risk perception that shifts constantly, changing the investor’s attitude towards certain assets such as equity, hence giving the impression that the risk tolerance has changed.
What Drives Risk Capacity?
When talking about risk capacity, people often say that the asset level is an important factor because investors with more assets (relative to their goals) can afford to take losses in down markets. The opposite is also true: Those with more assets can also afford not to take the risk because they don’t need the extra return. Unfortunately, for those with fewer assets, they can’t afford to lose money, and they also can’t afford not to take the risk because they need the return.
The ultimate driver of risk capacity is the investment horizon. Various cash flow considerations affect the investment horizon, hence the risk capacity.
Combining Risk Tolerance Capacity in Proposal Generation
After risk and behavioral profiling, it is time to generate an investment proposal.
Some systems only consider the client’s risk tolerance, while others, for example, target date funds, only consider time horizon. Both methods are flawed.
The right approach is to combine risk tolerance and risk capacity, which can be proxied by time horizon.
For risk tolerance, it needs to consider both members of the household.
Risk Perception, Risk Composure, and Investor Response
Changes in risk perception reflect a combination of market changes and behavioral biases. An event or trigger causes the change in risk perception, and risk composure determines the response. Behavioral biases such as loss aversion, lack of financial market knowledge, and personality traits influence both risk perception and composure, creating their correlation.
While risk perception can shift dramatically, financial advisors often dismiss it as irrational. Shifting risk perception partially reflects market reality. Advisors must acknowledge this to validate the client before discussing how loss aversion and recency bias magnify fear and the need for an objective risk view.
To recalibrate risk perception, advisors can show clients longer-term risk and return over a relatable time horizon. Awareness of biases helps clients become disciplined investors, regain composure, and minimize impulsive actions.
Can We Measure Risk Composure?
My firm, Andes Risk, introduced a method to first break down the investor behavior into a set of factors including the investor type (passive investor, trend follower, etc.), behavioral biases, and financial IQ, each of which is independently assessed, and then roll them up into the Behavioral Risk Index™, a single number from 0-10 that indicates how likely a client may respond irrationally to market turmoil.
Conclusion
An investor’s Risk Profile has four components: tolerance, capacity, perception, and composure. In wealth management, the focus has been on measuring risk tolerance and risk capacity. It is time to talk more about risk perception and risk composure to get a fuller understanding of the risk profile of clients.
Helen Yang, CFA, is the founder and CEO of Andes Risk, a Lexington, MA-based provider of technology solutions for financial advisors.
This page reflects revisions from the original article.
