Risk Tolerance Assessment

An earlier version of this article first appeared on the Alpha Architect blog.

When I attended the Harvard Business School 40 years ago my favorite class was Managerial Economics.  It focused on decision making under uncertainty [1]. The first thing to understand is the concept of expected value. You determine this by multiplying each event's outcome by the probability of its occurrence. You then add them all together. For example, the expected value of a coin flip where you win $10 with heads and lose $5 with tails is (.5 * $10) + (.5 *-$5) = $2.50. We should be indifferent between playing this game and receiving $2.50 without doing the coin flip. In this case, $2.50 is both the expected value and the “certainty equivalent,” or what we would accept for certain instead of playing the game.

Let’s say we raise the stakes and with the same one-time coin flip we could win $10,000 with heads and lose $5000 with tails. Our expected value is $2500, but the amount we would accept for certain may now be different than $2500. Those who are risk seeking might play the game for an amount equal or greater to its expected value of $2500. Those who are risk averse would accept less than $2500 instead of playing the game. Someone conservative, who does not like the idea of losing $5000 on a coin flip, might pay something to not have to play.

The amount of risk aversion we have depends on the size of the outcome relative to our financial condition. Because of risk aversion, we buy insurance having a negative expected value (and a positive one for the insurance company) in order to avoid the risk of catastrophic loss. On the other hand, risk seekers may buy low-cost lottery tickets with extremely negative expected values for the small chance of an enormous payoff. This can y be especially a ppealing to those h aving little to lose and much to gain .

Risk Tolerance   

Risk tolerance defined by the ISO 22222 Personal Financial Planning Standards is “the extent to which a consumer is willing to risk experiencing a less favorable financial outcome in pursuit of a more favorable financial outcome.” It is an assessment of our psychological ability to deal with uncertain outcomes. It is not symmetric due to loss aversion. Investors will of ten trade $1.5 to $2 in gains to avoid $1 in losses [2].

Risk tolerance is generally a stable personality trait. But it is subject to situational influences, such as our mood, and may change due to our life experiences, such as aging.

   

   

   

   

We cannot however look at risk tolerance just once and then forget about it. Risk tolerance does not take into account life changing events and shifting investment goals. W e should periodically reevaluate risk tolerance, which is easy to do using the above tools.

Example of How to Use RTQs

I have three proprietary dual momentum models . One focuses on global equities, the second uses a global balanced stock and bond portfolio , and the third is a mult i-asset core model . I encourage investment professionals who license my models to use RTQs with their dual momentum clients. This can help them decide which model(s) best suit their investors' risk preferences while meeting their investment goals.

[1] See Von Neumann and Morgenstern .

[2] See Tversky and Kahneman (1979).

[3] Another publicly accessible questionnaire that combines risk tolerance with other factors is in the Financial Planning Practitioner’s Guide   by the Canadian Institute of  Financial Planners.