Sometimes it can be easier to understand concepts that apply to financial risk-taking by looking at them in a different domain. Risk tolerance is domain specific, there being five domains: physical, social, health, ethical and financial. Let's look at an example of physical risk-taking.
For more than 50 years I have been a keen body-surfer. Some years ago I lived on Bronte beach, a surf spot in Sydney, and was able to indulge myself whenever I chose. On some days I couldn't find the time but on other days, when I did have the time, I still chose not to surf.
Why not? For one of two reasons, either the surf was too big and there was too much danger or the surf was too small and there was not enough fun. My physical risk tolerance didn't change from one day to another, what changed was my perception of the risk/reward being offered on that particular day. So my behavior changed, not because of a change in my risk tolerance, but because of a change in how I perceived the situation.
Adjacent to Bronte beach are two other beaches, Tamarama and Coogee. Tamarama is a more dangerous beach. On any given day the waves are usually bigger there than at Bronte. On the other hand, Coogee beach usually has much smaller waves. When the waves were too small at Bronte, I would consider surfing at Tamarama. Similarly, when the waves were too big at Bronte, I would consider surfing at Coogee.
We can think of this stretch of the Sydney coastline as representing the investment market, with Coogee being a 30% stocks portfolio, Bronte a 50% stocks portfolio and Tamarama a 70% stocks portfolio. Just as the general surf conditions will impact differently on the three beaches, so general market conditions will impact differently on the three portfolios. Even though risk tolerance hasn't changed, the choice of beach/portfolio can change depending on perceptions of risk/reward.
Risk behavior is not solely determined by risk tolerance. Risk perception is also a factor, as are goals and perceived alternatives, not to mention risk capacity.
At the risk of taking this analogy too far, let's consider risk capacity. In any particular surf conditions there will occasionally be a set of much bigger waves. When I was younger, fitter and had better lung capacity, I could handle a set of waves which today would drown me. So while the general surf conditions might be okay on a particular day, the possibility of a big set could, today, persuade me not to surf because of my reduced risk capacity.
As an experienced surfer I am very confident about my surfing decisions. Interestingly, though I am also an experienced investor, I am less confident about my investing decisions. In my view, it is easier to understand the surf as it relates to my physical self than it is to understand investment markets as they relate to my financial self.
Our clients are usually not experienced investors and, even if they are, a second opinion and some expert guidance can be invaluable. To fulfil our role in untangling risk for clients, we need to have a proper general understanding of market risk and proper specific understandings of our clients’ risk tolerance and risk capacity. Successfully guiding clients through the risk maze not only ensures that they make the best decisions for them but, by increasing their understanding, will also give them more confidence in those decisions.