Reckoning with Risk (8): Risk Capacity, Appetite, Tolerance and Perception

A major concern of every investor relates to taking on risk.  We generally want to avoid it (in the sense of losing money) but we’re also ticked off when a risk-averse strategy underperforms.  What we’re really talking about is risk capacity, which (as I have noted before) is largely a joining of risk appetite and risk tolerance.  Unfortunately, the theoretical and the practical are often disconnected at precisely this point.

Risk appetite is about the pursuit of risk (in the probabilistic sense rather than in the sense of losing money). If I am at or near retirement and have saved what I need for it, my risk appetite should be small.  If I am 22 and likely have a long investment life ahead of me, it should be far larger.  Every investor should regularly and routinely ask what success will look like and then go about figuring out how best to get there.  That process will necessarily include a careful analysis of risk appetite (or need).  It begins with the neglected art/science of estimating expected returns for prospective portfolios.

Risk Tolerance relates to the degree of uncertainty that an investor can handle with respect to a negative change in the value of his or her portfolio.  Sadly, it seems as though our risk tolerance is highest when things are going best and lowest when things are at their worst.  I don’t need liquidity (until I do).  Ascertaining risk capacity requires an analysis and a merger of appetite and tolerance.  It is a function of capability (how much – as objectively as possible – you can carry) and maturity (your ability to cope with risk).  This maturity relates to emotions (will you panic and sell at the wrong time?) but also to control (how do you deal with uncertain outcomes?).

However, it seems obvious that these determinations are anything but static.  Every financial professional has had clients love a lower risk approach when they are afraid but decide it’s horrific when the market is hot (even for relatively brief periods) and the lower risk strategy underperforms.  Similarly, an extremely aggressive investor can suddenly decide that the aggressive strategy wasn’t right after all when the market heads south.  Clients will even look at individual securities or strategies within a diversified whole and criticize specific losses despite the overall portfolio’s solid performance in line with reasonable expectations.

But wait a minute.

As Michael Kitces has pointed out, a recent study using FinaMetrica data joins a growing body of research suggesting that client risk tolerance  is actually remarkably stable, and that what’s changing through the market cycle is not risk tolerance, but instead risk perception. This research discovered – with a large class of investors examined both before and after the 2008-09 financial crisis and carefully controlled to eliminate other factors – that only a very small number of investors reduce their risk tolerances during crisis.  That result is consistent with other research and FinaMetrica’s own analysis showing that despite much volatility within the world markets over the past 12 years, average risk tolerance has remained remarkably stable. The most significant implication of this research is that financial professionals struggling with unstable client investment behaviors should focus more on managing risk perception, rather than blaming changing client risk tolerances.  In other words, something constructive can be done about the problem.

Kitces argues that investor behavior is driven by two primary factors:  risk tolerance and risk perception. As he sees it, risk tolerance determines whether one is willing to take a specified risk in pursuit of a potential reward while risk perception is one’s subjective evaluation of whether a particular investment is consistent with that risk tolerance. 

On account of recency bias, we tend to focus excessively on what has happened recently to the exclusion of the broader context and to project the recent into the indefinite future.  Thus an investor who has suffered a significant drawdown (but one that ought to be within the expressed risk tolerance) will look to bail not because his or her risk tolerance has changed, but because s/he sees (via risk perception) the experienced drawdown as the beginning of an intolerable loss.

As Kitces argues (very persuasively), this will be a distinction without a difference to investors who have not carefully, comprehensively and objectively measured their risk tolerance.  Otherwise, it will be all but impossible to tell if the problem is that the risk tolerance was poorly assessed or that risk perception is the problem.  For advisors, managing risk perception means providing the ongoing communication (lots of it) necessary to allow the client correctly to perceive his or her investment risk and thus fight the natural tendency to over- and under-estimate the risks throughout the market cycle.  It must begin with realistic expectations before and as the portfolio strategy is undertaken and must continue throughout the management (both portfolio and client management) process. 

Nobody is happy about losing money.  But if expectations are in line with the portfolios created, drawdowns will be much more tolerable.  The key for financial professionals is to communicate, communicate and communicate some more about goals, objectives, risks, rewards and expectations.

7 thoughts on “Reckoning with Risk (8): Risk Capacity, Appetite, Tolerance and Perception

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