The Three Faces of Risk; What you need to know about risk tolerance.(Financial Planning)

Byline: Pamela J. Black

The market crash of the past 10 months would give anyone pause to question the utility of standard client risk profile questionnaires. For example, how is it that clients seem to have a high risk tolerance during bull markets and a low risk tolerance during bear markets? Certainly many clients seemed to have changed their risk tolerances recently.

How can you get a more accurate picture of a client's risk tolerance? It helps to understand the three primary components of a client's risk profile: risk tolerance, risk capacity and perceived risk.

Risk tolerance is a psychological trait like intelligence, personality or aptitude. It measures how an individual feels about taking risk.

For example, have you ever been a passenger in a car when the driver seems to be going either very fast or very slow? The speed obviously feels right to the driver, but you're uncomfortable. Either you're anxious that there will be an accident or you're wondering why the driver is just creeping along. Many factors determine a person's driving behavior, but a key element is the person's tolerance for risk. The fast driver has a higher risk tolerance than you do, the worried passenger and the slow driver's risk tolerance is lower than yours.

Risk capacity is a financial consideration, i.e., how much risk the client can afford to take. Can the individual's financial situation withstand the impact of a negative outcome? Imagine that your 75-year-old mother decides to go skateboarding. You try to talk her out of it because while she may have the appropriate risk tolerance for it-after all, she wants to do it-she doesn't have the appropriate risk capacity: a fall at her age could lead to a broken hip or some other incapacitating injury.

So you give the skateboard to your eight-year-old son instead. He doesn't want to try it because his friends have had accidents and he doesn't want to get hurt. This is the opposite situation: He has the risk capacity because his reaction time and coordination are as strong as his young bones and he will recover quickly from any injury. But he doesn't have the tolerance, the psychological inclination to take this type of risk.