I was reading an Investment Executive’s article about “About Understanding Tolerance versus capacity” when I came across the following statement:
“You also should determine your clients’ capacity for risk, which reflects the amount of risk they will need to take in order to achieve their goals.”
Apologies, but capacity for risk should actually be an upper bound on the risk you can afford to take, and nothing to do with the amount of risk investors will need to take in order to achieve their goals.
The less capital you have relative to your financial demands, the lower your risk capacity. What this means is that for any given risk, the impact on the ability of your assets to meet your needs is greater the greater your demand on your capital. This may actually mean that you may have to scale down your goals, in which case your risk capacity is constraining your goals as opposed to defining the risk you will need to take to achieve them.
A lower risk capacity means that you are going to have to minimise the difference between the upper and lower bounds on potential portfolio performance (less volatile, more certain)and take less risk. Increasing risk to enhance return places your financial security at greater potential risk.
On the other hand, a high risk capacity, which is a low financial demand on your assets, does not necessarily mean that you should be taking a higher level of risk to increase returns; this very much depends on your risk aversion and investment preferences, current market conditions and the investment discipline being followed.
How do you determine risk capacity?
Well, if you have no present or future potential demands on your assets you have no limitations on how much risk you can take because whatever the risks, they are not going to impact your personal financial situation.
But, if you have financial needs over time, then risk capacity involves modelling your financial demands relative to your assets via a set of risk and return assumptions that assess the extent to which your assets can cope with significant risks while still meeting your needs. The difficulty is making sure the assumptions are robust and realistic since the risk capacity can be high on optimistic assumptions and low on pessimistic assumptions.
So, risks of the the investment process erring in determining risk capacity are potentially much greater than the client erring on risk tolerance. But, risk tolerance and risk capacity do in fact intersect. An investor who would be comfortable with the risks of the recommended asset allocation derived from the risk/return assumptions underpinning the risk capacity analysis would be risk neutral. Someone who wanted to take less risk and lower their risk capacity voluntarily would take an increasingly conservative attitude to risk and vice versa for those who wish to override the risk capacity allocation and take higher levels of risk.
In fact, an investor cannot assess their attitude to risk, their risk aversion without an idea as to the risk capacity asset allocation that would meet their short and long term financial needs while coping with significant risk. Without this allocation they have no idea how much risk they will be exposed to and how the portfolio will cope with risk. It may be that after seeing the portfolio structured relative to risk capacity they feel that they are risk neutral as opposed to being more conservative than the risk neutral risk capacity portfolio.
What does all this mean? It means that risk aversion and risk capacity are all relative and dependent on where in the risk universe both the client and the adviser lie, but both hinge to a large degree on the client’s liability profiles.
Of course, investors are likely to over and underestimate risk tolerance/aversion depending in which direction markets are moving, but this is more likely to happen if an adviser fails to properly educate investors about the true “out of equilibrium” nature of risk and return and lacks a point of reference portfolio benchmarking system that relates asset allocation to risk capacity.
Also important is trying not to make a direct relationship between higher risk and higher return seem certain, since this is not always as linear a relationship as it is made out to be. .Higher risk only equates to higher return in a general equilibrium model and only, on average, over the full potential distribution of return outcomes. Higher risk assets at cyclical peaks are veritable coffins compared to high risk investments at market and economic low points.