For most investors, risk tolerance, financial ability to take on risk, and the optimal portfolio risk will be aligned closely. In other words, they’re close to each other on the efficient frontier. For some investors, however, the balance is out of alignment.
Often when investors meet with a new financial advisor, they will be asked to fill out a risk tolerance questionnaire. There are three problems with this approach:
The questions are all hypothetical. In real life, investors often act differently than they assume they will act when faced with adversity. Being asked how you’d feel if your portfolio dropped 50% is much different from actually watching it happen.
A risk-tolerance-based portfolio may not meet financial objectives. A portfolio that meets risk tolerance objectives could fail to meet financial objectives. For example, a risk-averse investor might end up with a portfolio that won’t eventually be worth enough to support him or her during retirement.
Risk tolerance may not align with financial reality. What you can psychologically tolerate might be greater than your financial capacity to do so. For example, an investor who trades futures can psychologically handle the volatility, but a large bet that goes wrong could wipe him out financially.
First and foremost, the capacity for financial risk should dominate your portfolio allocation decisions. Never take more risk than you have the money to absorb. If your current finances cannot handle a temporary setback, then risk should be avoided. Investors should strive for the optimal risk point where there is a good tradeoff between risk and reward.
References and Further Reading
Allison, D. (nd). Matching Investing Risk Tolerance to Personality. Investopedia.
Butler, C. (2018). What Is Your Risk Tolerance? Investopedia.
Edwards, N. (2017). Investor Risk Tolerance: Ability and Willingness. Investopedia.
Last Updated: 6/25/2018