Discussions about risk generally revolve around two questions, and they are often used interchangeably. The first question is, "How much risk can you handle psychologically?" And the second one is, "How much risk should you take on?"

The answer to the first question is not always identical to the answer to the second, even though some financial advisors act like it is. Question one is about risk tolerance; how comfortable we are watching our investment portfolios take a hit. But, just because a financial daredevil wants to take a risk, that doesn't mean he or she should. That's where Question two comes in. Unfortunately, risk tolerance alone is often used as the key factor when determining the asset allocation for a portfolio. This article will show how a blend of three factors that should be considered when creating a long-term investment strategy: risk tolerance, the financial capacity for risk and the optimal risk.

SEE: What Is Your Risk Tolerance?

Risk Tolerance
Risk tolerance is a measure of your willingness to accept higher risk or volatility in exchange for higher potential returns. Those with high tolerance are aggressive investors, willing to accept losing their capital in search for higher returns. Those with a low tolerance, also called risk-averse, are more conservative investors who are more concerned with capital preservation. The distinction is justified only by the investor's level of comfort.

A risk-tolerant investor will pursue higher potential reward investments even when there is a greater potential for a loss. A risk-tolerant individual might not sell his stocks in a temporary market correction, while a risk averse person might panic and sell at the wrong time. On the other end, a risk-tolerant person could be seek out high-risk investments, even if they add little to his or her portfolio.

Risk tolerance is a measure of how much risk you can handle, but that is not necessarily the same as the appropriate amount of risk you should take. That brings us to the second risk assessment that should be done.

Capacity to Accept Risk
When applying the concept of risk to investing, there are really two types of risk-related attributes that are quite distinct. One is a psychological attribute known as risk tolerance which we've already discussed. The other deals with financial ability or capacity to tolerate risk.

Example - Differences in capacity to tolerate risk.

Let\'s consider the fate of three investors who each see a 50% drop in the value of their portfolios.
  • C. Montgomery Burns: Mr. Burns is over 100 years old and has made billions as a captain of industry and atom smasher. His estimated net worth is $16.8 billion.
  • Homer Simpson: Homer is in his late-30s and works as a safety inspector in Mr. Burns\' nuclear plant. He has a family to support and is slowly nearing retirement. We\'ll be generous and give him a retirement portfolio of $100,000.
  • Bart Simpson: At age 10, Bart is just beginning his investment career. He recently won a court settlement against the Krusty-O cereal company for $500, which is his current net worth.

A loss of 50% would drop Mr. Burns down to a paltry $8.4 billion. While Burns would no doubt be incensed at the loss, $8.4 billion is still enough to buy him all the ivory back-scratchers he could ever need. Bart, too, has the capacity to absorb a financial hit of 50%. He has many years to continue saving and investing before he needs to think about retirement.
Homer, however, does not have the financial capacity to tolerate risk, even though he might be more than willing to gamble it all away on pumpkin futures or some equally risky investment. He has a family to support and less than two decades left until retirement. A 50% drop in the value of his portfolio would be crippling - Doh!

Financial risk capacity can be measured in many different ways, including time horizon, liquidity, wealth and income. People who have a high liquidity requirement (they could need access to their money at any time) are constrained to how much risk they can take. They are forced to avoid investments that might be potentially lucrative because they do not offer the required liquidity. Over the long term, volatility of the markets is dampened, and returns will move toward long-term historical averages. The longer the time horizon, the greater the capacity for risk as the short-term volatility of the markets loses its significance.

Those with high income and high wealth can make higher-risk investments because they have funds coming in regardless of the market conditions. Similarly, young investors, with limited funds to invest, have the capacity for high risk, because they have longer time horizons. Any short-term drops can be waited out, lowering the chance of having to withdraw before the markets bounce back. This brings us to the third consideration, the optimal risk of the portfolio itself.

Optimal Risk
Quite different from risk tolerance and risk capacity is optimal risk. The previous types apply to the individual investor, but optimal risk applies to the construction of risk-efficient portfolios. Optimal risk of a portfolio comes from modern portfolio theory. Central to the theory is the fact that investors are trying to minimize variance (risk) at the same time that they are trying to maximize their returns.

SEE: Modern Portfolio Theory: An Overview

In this theory, there is a perfect combination of asset classes. This is the point where adding another unit of risk will provide the most marginal return. Putting it another way, it is the point you will get the most bang (return) for your buck (risk). This point is found on the curve of the efficient frontier (Figure 1).

Figure 1: Curve showing the efficient frontier. Optimal portfolios should lie somewhere on this line.
Source: Investopedia.com © 2008

The efficient frontier is determined through an optimization that analyzes various combinations of different asset classes. It is based on the historical relationship between risk and return and the correlations between the various asset classes.

SEE: Diversification: It's All About (Asset) Class

As with any calculation, the information going into the model might be imperfect, which could result in an incorrect result. Also, as it's a historically-based calculation, it will not necessarily hold in the future. There is no guarantee that the optimal mix for the past 10 years will be the same as the optimal mix for the next 10.

How Much Risk Should You Take On?
For most investors, risk tolerance, financial capacity for 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:

  1. 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 30% is much different than actually watching it happen.
  2. 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.
  3. 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. An investor should never take more risk than he or she has the capacity to absorb. As an example, if you needed all your money next week, you would not invest all of it in the stock market today. If your current finances can not 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.

The Bottom Line
When developing a long-term investment strategy and strategic asset mix, there are three types of risk that should be considered: the risk tolerance of the investor, the financial capacity for risk and the optimal risk. Understanding the differences among these three helps investors develop a portfolio with the risk that is most appropriate to their circumstances.

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