How Much Risk Should Clients Take?

Determining the degree of risk that is appropriate and tolerable in clients’ financial plans is central to an advisor’s role. I will show how advisors should deconstruct risk into six components and then integrate them using a framework to provide the best recommendations for clients.

I'll focus this analysis around the time of retirement, with clients needing to plan how to spend down savings and how much investment risk to take. Clients need to develop retirement plans that will achieve their financial goals, but they also need to be able to psychologically withstand the market volatility that such plans may entail. A retirement plan that meets the financial plans on paper but results in the client bailing out when markets are down is not viable.

Plans should first be developed with a focus on the financial goals. The psychological issues can then be considered, perhaps calling for cutbacks in risky investments and setting more realistic financial goals. Ideally the advisor and client would handle the psychological issues in a way that minimizes their disruption on the financial plan.

This idea of separating the financial and psychological issues was recently proposed by Michael Kitces in a blog post. He raised the concern that many of the tools used to assess risk tolerance actually attempt to measure the combination of risk tolerance and risk capacity. He demonstrated how these combined measures can send the wrong signals and lead to inappropriate investment advice. The methodology I propose builds on Kitces' recommendation of separating risk tolerance and risk capacity.

Risk components

A client's overall risk profile consists of six components. A brief description of each component follows:

  1. Risk tolerance – the psychological capacity to tolerate turmoil in investment markets without undue anxiety.

  2. Risk perception – the client's view of the riskiness of financial markets, which may be influenced by current market volatility.

  3. Loss aversion – a behavioral economics concept that describes the tendency to strongly prefer avoiding losses to acquiring gains.

  4. Risk aversion – a classical economics concept that describes the reluctance to accept uncertain payoffs in favor of certain payoffs with lower expected values.

  5. Required risk – the amount of investment risk a client needs to assume in order to build a viable financial plan.

  6. Risk capacity – the financial capability to withstand losses without undue disruption to financial plans.

The six different risk components are a recipe for confusion. I'll attempt to sort them out.