Michael Kitces, the director of financial planning for Pinnacle Advisory Group, has conducted a significant amount of research into breaking down and examining risk in financial settings. Building on the research of others, Mr. Kitces has divided the traditional model of “financial risk tolerance” into three categories:
- Risk capacity
- Risk perception
- Risk attitude
The secret to gaining a clearer insight into your own risk tolerance is to weigh these categories on an individual basis and not lump them together.
Risk capacity is the most straightforward and least emotionally charged of the three categories. Risk capacity relates to your ability to take on uncertainty — especially in regards to a negative event. For instance, if you need $5,000 a year in retirement, and you have a portfolio worth $1 million, then you have the option, or capacity, to take on more risk. On the other hand, if you need $5,000 a year in retirement and you have a portfolio worth $50,000, your capacity to take on risk is diminished. Another factor of risk capacity is time. If you need the money in 30 years, then your risk capacity is higher than if you need the money for your mortgage payment next week.
Risk capacity generates a very objective set of guidelines for your financial assets. However, as we are about to see, risk attitude and risk perception can muddy the waters.
Risk attitude is how comfortable you are with uncertainty. If the fear of negative events causes you emotional stress, then your risk attitude is low. By default most of us prefer to minimize uncertainty and mitigate bad events. Insurance is the natural byproduct of the human desire to protect against the unknown. In the portfolio world, diversification is used to help insulate portfolios. Diversification in the portfolio setting is based on the theory that a bad event affecting investment A is unique to investment A and will not impact investment B by the same magnitude. When we incorporate risk attitude, the portfolio objectives based solely on risk capacity can become cloudy. The investor who has $1 million can choose a conservative or aggressive portfolio because the investor has the risk capacity that can accommodate a wide range of risk attitudes. The investor who has $50,000 has to consider tradeoffs if risk attitude is high, but risk capacity is low. The $50,000 investor may be forced to rethink retirement goals, objectives and timelines.
Risk perception is the most emotionally charged input. Risk perception relates to how you weight the positives and negatives associated an opportunity. Risk perception is very subjective and can change quickly. Asset bubbles and bursts are examples of risk perception taken to extremes.
Amos Tversky and Daniel Kahneman, two economists, have been conducting research on risk perception for years and the results are both fascinating and sobering. One lesson that we can take from the research on risk perception is that we need to be aware when emotions are driving the decision process and understand how much we allow ourselves to be influenced by these emotional impulses. (The research has shown that this is very hard to do!) Incorporating risk perception into the equation has the potential to undermine the recommendations from both risk capacity and risk attitude. In extreme scenarios, poor risk perception can result in financial disaster.
As investors we occasionally reflect, after a negative event, on why we seem to tolerate no risk in some parts of our financial lives, while readily agreeing to extreme amounts of risk in other endeavors. Often, the answer lies in the fact that we have bundled all three risk factors together — as opposed to analyzing the differences between the amount of risk needed to achieve our goals, the amount of risk we can handle, and the amount of risk we perceive. Viewing — and treating — risk capacity, risk attitude and risk perception as separate influences is a giant step toward creating your “best fit” portfolio and making clearer overall financial decisions.