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March 23, 2023 at 01:38 PM
What You Need to Know
- Much of the foundational academic work about risk and risk tolerance is well understood by advisors, but there are emerging frameworks and concepts to keep apprised of.
- One key concept is risk literacy, which represents the degree to which individuals understand and interpret risk.
- Ultimately, a good grounding in the psychology of risk and risk-taking allows advisors to better serve their clients, especially in the realm of retirement planning.
Financial advisors who have been in practice for a while are, generally speaking, going to be familiar with many of the basic concepts and definitions that feed into the topic of “risk tolerance.”
Firms of all stripes use risk tolerance questionnaires to learn more about their clients to help facilitate what can be difficult investment management decisions — and to set all sorts of planning goals, from ensuring short-term financial stability to pursuing retirement readiness over the course of decades. Many of these questionnaires, in turn, base their approach in seminal academic research from the 1970s through the mid-2000s.
However, the work of researchers and academics specializing in the field of risk theory hasn’t stopped in the intervening period, and in fact, there are a number of new emerging concepts that can help advisors better serve their clients.
This is one of the key insights to be gleaned from the opening chapter of “The Psychology of Financial Planning,” a new guidebook developed by the CFP Board of Standards and ThinkAdvisor’s parent company, ALM (National Underwriter/ALM, April 2022). Written by Swarn Chatterjee and Dave Yeske, the chapter speaks to the process of framing advice in light of a client’s risk tolerance, with the goal of helping advisors to identify and respond to gaps that exist between perceived and actual risk tolerance.
What Is Risk, Really?
As Chatterjee and Yeske write, defined simply, “risk” occurs when the future outcome of an event cannot be determined with certainty and is the basic building block upon which the key concept of “risk tolerance” is built.
According to the authors, “financial risk tolerance” is an important concept in financial planning because it is associated with a number of money-related decisions that people make — and the related outcomes they experience. In practical terms, it is defined as the maximum amount of uncertainty that an individual is willing to accept when making financial decisions that involve a probability of loss.
In general, Chatterjee and Yeske write, financial planners have various quantitative tools at their disposal to help their clients make a plan to achieve their financial goals, but planners must often rely on subjective assessments for understanding their client’s risk tolerance.
In this effort, it can be helpful to keep in mind the various other risk definitions and concepts that have been developed over the decades, the paper suggests. For example, it is important to understand that “risk capacity,” or the extent to which an individual may be able to withstand the outcome of a financial loss without suffering unacceptable disruptions to lifestyle or goals, is not the same thing as “risk tolerance,” strictly speaking.
Even if a person has a very high subjective risk tolerance, their actual risk capacity can be far lower, for instance, if they are constrained by limited financial resources across wealth and income. On the other hand, those with substantial capacity to take on risk may nonetheless be highly risk averse, given their own unique point of view about gain and loss.
