While academics have developed complex instruments and formulas in an attempt to quantify risk tolerance, the practical assessment of an investor’s willingness to tolerate risk is almost entirely qualitative. For financial advisors, the task is quite complex. The advisor must evaluate the client’s willingness to assume risk by listening to both the explicitly stated and implicitly communicated risk factors.
Advisors often ask Investors to complete a risk tolerance questionnaire to aid in the assessment of risk tolerance. There are countless varieties of these surveys floating around, but a common format involves a series of questions that attempt to establish a relative measurement of investor sentiment towards risk-taking. While the actual questions may range from blunt to ambiguous, the goal is to try to determine how an investor has felt about risk in the past, feels about investment risk presently and how they might respond to the effects of risk in the future.
Although sometimes difficult for one to assess of themselves, when working with an advisor, the advisor might also factor in clues about an investor’s willingness to accept degrees of investment risk gleaned from previous conversations or aspects of the investor’s life that might affect the way they perceive investment risk. This is the implicit component of the evaluation.
The amount of investment risk that an investor is willing to tolerate is an essential consideration. It is often little more than a matter of an investor’s intrinsic psychology. Yes, one’s willingness to assume risk can often be shaped to some degree by education. However, what an investor identifies as the risks they should or shouldn’t take because of what they have learned can sometimes be very different from how they feel when risks materialize. Feelings have a tendency to supersede knowledge under stress.
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Last Updated: 6/25/2018