Financial planning is a process for dealing with financial risks. Although investors mostly have access to the same investment assets, every investor faces different combinations of risks. And every investor encounters those risks differently. As a result, we need a risk framework which facilitates useful discussion. This is because I find that portfolio risk is one of the hardest concepts to discuss.
I want to discuss a risk framework I find helpful for thinking about and discussing risk.
This involves creating a risk profile which consist of three parts: need, preference, and capacity. This three-way distinction draws on a review written by John Grable in 2017 which defines the terms:
- Risk need: “The amount of risk an individual needs to take to reach a financial objective; typically based on a predetermined required rate of return.”
- Risk preference: “An individual’s general feeling that one situation is better than another.”
- Risk capacity: “An objective evaluation of an individual’s financial ability to withstand a financial loss.”
In this risk framework I view “need” and “capacity” as being somewhat objective limits on the amount of risk an investor should take. “Need” defines the least amount of risk necessary to reach a goal. “Capacity” defines the most risk the investor can afford to take.
Never take less risk than you need to take nor more risk than you have capacity to take.
If an investor needs a 3% real return to retire, it is not feasible to invest exclusively in bank CDs. The investor NEEDS to take more portfolio risk than that to accomplish their objective. As a result they will probably need allocate a significant portion of their investments to stocks. The only alternative is to adjust their goal.
Or imagine a parent who has $20,000 in January and needs to pay that amount for college in August. This investor has limited CAPACITY to take risk, primarily assets with little or no chance of declining in value. Examples are savings accounts, Treasury bills, stable value funds, etc. Some people (like Larry Swedroe) refer to “capacity” as “ability” to take risk. I prefer “capacity” because I think it more clearly articulates the economic (rather than behavioral) nature of this constraint.
Between the lower bound of “need” and the upper bound of “capacity” is a region I call “preference”. Grable 2017 defined preference in his risk framework as a “general feeling”, which I think captures the subjective nature of this risk dimension.
The concept of preference in this risk framework serves as a composite for several distinct but related subjective and behavioral traits.
- Risk aversion: “the inverse of risk tolerance”. Or “willingness to engage in a risky behavior in which possible outcomes can be negative”.
- Risk composure: “An individual’s propensity to behave in a consistent manner.”
- Risk perception: “A subjective evaluation, based on a cognitive appraisal, of the riskiness of a decision outcome.”
In my experience, this is the part of the risk framework which is most difficult to discuss.
Different people perceive risks differently. They have varying degrees of comfort in thinking probabilistically and evaluating the expected payoffs of uncertain events.
Even people with similar perceptions can arrive at different conclusions about what is acceptably risky. One person might view a risky choice as “obviously superior” while another might say it’s “clearly not worth the risk”. And composure is often the element in the room. Because people are not robots we don’t behave consistently across time. The stated risk tolerance of investors is much higher during bull markets than during bear markets, for instance. A lack of consistency is why “buy and hold” and “stay the course” are staples of financial advice. Many investors lack of composure during times of stress. As a result, people sometimes make poor decisions at the worst possible time.
Better behaviors around risk can sometimes be coached but often they simply need to be accommodated.
I’m no psychologist, but I’ve learned this by working with clients and investors over the last two decades. Ideally portfolio risk preference points the investor to a middle ground. So they should have no conflicts if preference steers them above the level of need and below the level of capacity.