Lesson 2 of 7 · 14 min
Risk objectives and risk tolerance: ability vs willingness
Risk objectives can be absolute, relative or liability-based, and the client's risk tolerance combines an objective ability to bear risk with a subjective willingness to take it; when they conflict, the lower one usually wins.
In short
- Risk objectives specify portfolio risk in line with the client's risk tolerance. They can be absolute (e.g. no more than a 5% loss in a year), relative to a benchmark (e.g. within 3% of an index), or a combination.
- Absolute objectives are made practical as probability statements, e.g. a 95% value at risk. Relative objectives are measured with tracking risk (tracking error), the standard deviation of portfolio minus benchmark returns.
- Liability-driven investing (LDI) sets risk objectives relative to known future obligations, e.g. minimising the chance a pension plan cannot pay benefits.
- Ability to bear risk is objective: time horizon, income, wealth relative to liabilities. Willingness to take risk (risk attitude) is subjective, assessed by discussion or psychometric questionnaires.
- If ability is low but willingness high, assess tolerance as below average. If ability is high but willingness low, counsel the client, but do not try to change their personality. The prudent rule: go with the lower of the two and document it.
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