Risk Tolerance (Part 1)

Two weeks ago we looked at the concept of investment risk. Last week we discussed managing that risk. But important to both is knowing your tolerance to risk. In my practice we use a test developed by Fina Metrica out of Australia. I’ve found it quite effective. (They’ll let you take it for $30 at www.MyRiskTolerance.com.)

The problem is that this type of measure only tells us a portion of how you and risk get along. That’s because there is more to risk tolerance than your emotional ability to handle risk. So let’s take some time and discuss three aspects to risk tolerance that will give you a better picture of it: Capacity, Perception, and Attitude. I got the idea for this way of breaking down the discussion of risk tolerance from a presentation that Michael Kitces (www.Kitces.com) gave recently in San Francisco.

The first attribute of risk tolerance is Capacity. This is your ability to sustain a market decline without it causing you to reduce your standard of living now or in the future. This isn’t a rich vs. poor determination, but rather an income vs. expenses one. If your portfolio can reasonably produce double the income you need to live on, then you could sustain very large fluctuations in value without it affecting your lifestyle at all.

Capacity is the situation you bring to the table.

The next attribute is Perception. If you know that stocks often can drop 20% and sometimes drop 50% in a single year, you are less likely to be scared off when that actually happens. You know that they eventually go back up and that if you hang around long enough then things not only even out, but you make money. You also know that bonds, real estate, and commodities also bounce around. If you knew your bond portfolio could drop 15% and it did, you wouldn’t be surprised. If you thought bonds were equivalent to cash, you’d be shocked when they dropped.

Perception is the knowledge you bring to the table.

The last attribute of risk tolerance is Attitude. This is your psychological inclination to take a level of risk in exchange for a potential reward. Regardless of how much money they have and how much knowledge they have, some folks can and some folks can’t stand the bouncing around of the markets.

Attitude is the emotion you bring to the table.

Capacity (your situation), Perception (your knowledge), and Attitude (your emotions) all come together to be your true risk tolerance. You’re stuck with your current capacity, though by developing a spending, saving, and investing plan you can change it for the future. Perception is the easiest to change as it only requires study. Attitude, I believe, is mostly hard wired into you by now. Even after both the tech bubble bust and this current financial fiasco, research by Fina Metrica and our own experience is showing that people’s risk attitude has barely budged.

Next week we’ll look at how you can use these three aspects of risk tolerance to determine what level of risk you should take in your portfolio.

This article was published under the title "Risk Tolerance" in the Wichita Falls Times Record News on August 16, 2009.