A Different Approach to Risk Tolerance

By: Richard A. Anderson

For many investors, the word risk has a negative connotation. However, risk is a normal and required part of investing. While it can sometimes be uncomfortable to take risk, if you didn't accept some risk, the potential to achieve higher returns would not be possible. 

It has been common place to measure risk tolerance as your ability to withstand market volatility. Essentially, will you sell when markets decline? This is done by having you complete a risk tolerance questionnaire that asks a series of questions about your time horizon, need for income, investing experience, and attitude toward risk. The risk tolerance questionnaire calculates a risk score and this risk score determines how you will be invested. 

This approach has one significant flaw. By measuring risk tolerance as a single score, it fails to separate your willingness to take risk from your ability to take risk. Just because you can afford to take risk doesn't mean you want or need to take risk.

At HIGHLAND, we view risk along a different dimension. We don't view risk as volatility. Rather, we view risk as the probability that you will not reach your long-term financial goals. The three dimensions that comprise your risk profile are risk perception, risk tolerance, and risk capacity. Our approach to risk profiling builds upon our core belief that financial planning and investing go hand-in-hand. 

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Risk Perception is how you feel about risk at this very moment. Therefore, risk perception changes over time. When markets are rising and when markets are falling, we typically have a different view about risk in the market. This is a dimension that can't be objectively measured but we determine through conversation.

Risk Tolerance is the level of risk you are willing to take. This is an assessment of your attitude toward risk, or true tolerance to withstand declines in the market. Academic research and studies have shown that risk tolerance does not typically change over time. Risk tolerance is a dimension that we measure through the use of risk tolerance questionnaires. 

Risk Capacity is how much risk you are able to take. This is an assessment of your financial goals and objectives and considers your time horizon and need for income. Unlike risk tolerance, which might not change over time, risk capacity is more likely to change. However, risk capacity does not change based on market levels. Rather, risk capacity changes depending on your personal and financial goals and your timeline for achieving those goals. Risk capacity is a dimension that we measure through the financial planning process.

In short, risk perception, risk tolerance, and risk capacity can be boiled down to three questions: 

Risk perception answers "How do I feel about risk?" 

Risk tolerance answers "Am I willing to take risk?" 

Risk capacity answers "Do I need to take risk?"

Our different approach to risk tolerance that separates your risk profile into three distinct dimensions allows us to distinguish between your willingness and need to take risk. Once we establish your risk profile, we can then proceed to build an asset allocation strategy to meet your financial goals with the least amount of risk. We believe this approach leads to a successful and meaningful investment experience for you.

To learn more about our approach to determining your risk profile and how we integrate your risk profile with your financial plan, please contact a member of the HIGHLAND team.