AUTHORS:

Elke U. Weber

Joachim Klement, CFA

The term risk tolerance is defined and used in different ways. Whether risk tolerance is a stable characteristic of a given investor or also takes into account external circumstances (e.g., economic shocks or the domain of the decision) depends on how it is defined and measured. This brief focuses on a definition of risk tolerance prevalent in the practitioner community—namely, an investor’s willingness to take perceived risk or the trade-off an investor is willing to make between the perceived risk and expected return of different investment choices. This definition derives from a psychological interpretation of the risk–return framework of classical portfolio theory. It treats risk tolerance as an attitude toward risk and decouples this pure attitudinal variable from the perceptions of risks and returns—psychological variables in their own right and distinct from the expected value and variance of the distribution of possible outcomes.

Defined in this way, risk tolerance may differ among investors as a function of socioeconomic and biological differences but (with the exception of a brief boost during adolescence) shows stability across an investor’s lifespan, financial shocks, and other circumstances. Risk tolerance, in this sense, is the mediator that translates perceptions of risk and situational needs and constraints into decision and action.

The variables that change with market conditions and other circumstances are investors’ perceptions of investment risks and expectations of return. In contrast to risk tolerance, which attaches to an individual and her biological makeup and personality, these variables change over time in response to changing external conditions. Therefore, an investor’s risk-taking behavior (as revealed by her investment decisions) can look like it has changed, despite the stability in her risk tolerance. Perceived risks and expected returns are influenced by hopes and fears as much as by past returns and rational expectations and thus need to be assessed in their own right and possibly corrected.

Managing investor emotions through the ups and downs of financial markets is arguably a financial adviser’s most important task. Calm times provide an opportunity to discuss and formulate an investment policy for each client that can be consulted when emotions are running high. Managing risk perceptions requires the financial adviser to act more like a therapist than a mechanic. It is above all about managing expectations and emotions and helping clients to better deal with emotions when it comes to financial decisions. The end result of this process might be a portfolio that is not “optimal” in the sense of modern portfolio theory, with its assumption of econs, but rather a portfolio that “satisfies” the human need for investments that can be handled in the presence of changing emotions and changing risk perceptions.