One of the blog posts that Geoff Davey of FinaMetrica Ltd. wrote for AdvisorOne.com was called “Is Risk Bad?” He told me, “People often think of risk as a negative, but risk tolerance is a balance point between too much risk and not enough risk. I use a driving example: At a particular time on a particular day, there’s a speed you are comfortable with, a range of how fast or slow you like to go. That’s your comfort zone. For example, you could be driving at 50 miles per hour and might be willing to drive at 55, but not 60.”
FinaMetrica defines several kinds of risk sensitivity. “We talk about risk required, risk capacity and risk tolerance,” Davey said. “‘Risk required’ is the return required to achieve somebody’s goals. That’s a financial construct; just number-crunching. ‘Risk capacity’ is a numbers construct: To what extent can the client’s plan underperform? Maybe college education’s more expensive, or things don’t go as well as you expected they would. It covers investment, employment, kids’ health, education. How much of a setback can they cope with so that it’s not going to completely derail their plans? ‘Risk tolerance’ is the psychological construct: How much risk the client would prefer to take.”
Finally, there’s “risk perception,” the client’s view of the environment, which varies from time to time. Davey explained, “Toward the end of a bull market, they think the market’s not risky, while in a bear market, they think it’s very risky. Both times, their perception should arguably be the opposite. To influence these perceptions of risk, you need to educate.”
As Davey pointed out, when clients’ goals are out of line with their financial resources and the level of risk they would prefer to take, they need to either adjust their goals, spend less, earn more or invest differently. By helping them understand their human biases and misperceptions, you can help your clients move toward more rational decision-making in their work with you.