March 2017 Monthly Insight: Risk Tolerance, Risk Capacity, and Risk Perceptions

Posted By T. Lee Sherbakoff, CPA/PFS, CFP® on Mar 15, 2017


“The confidence people have in their beliefs is not a measure of the quality of evidence but of the coherence of the story the mind has managed to construct.”

— Daniel Kahneman

Risk Tolerance, Risk Capacity, and Risk Perceptions are important concepts in investing. As a goal-focused, plan-driven financial planning practice, we use these three concepts to help us determine the proper portfolio allocation for individual investors.  We consider the investor’s mental attitudes toward risk to determine Risk Tolerance. We analyze financial assets and goals for income, time horizons, and other goal funding requirements to determine Risk Capacity. And we gain an understanding of the investor’s biases toward risk and likelihood that these perceptions will change over time to determine Risk Perception. This process allows us to advise our clients on appropriate portfolio allocations.

Let’s try a little experiment.  Think back for a moment and try to recall how you felt during recent periods of market volatility—or imagine how you would feel today if we experienced similar circumstances.  How about just last year when the market lost roughly 13% between December 2015 and February 2016?  Perhaps recall the Fall of 2007.  October 9, 2007, was the market peak before the bottom fell out of the global market as a result of the global financial crises.  From October 9, 2007, to March 9, 2009, the S&P 500 fell 880 points and lost around 57% of its market value.  Or, we can look back over the last 30 years.  The S&P 500 has had average annual returns of 10.2%.  However, it has finished in negative territory seven times, including being down -0.76%, -1.54%, -6.56%, -10.14%, -13.04%, -23.37%, and -38.49%.  You can also throw in 2011, which closed at 0.00% change.

So, how do you feel now, just reflecting back on those historic events?  If you’re like most people, your stomach may have churned, your heart rate may have increased, and you may have breathed a little faster.  It’s a proven fact that experiencing the pain of down markets is more intense than the pleasant feeling of gains in an up market.  This is known as loss aversion and it refers to people’s natural preference for avoiding losses over acquiring equivalent gains: in other words, losing money feels twice as bad as making money feels good.

To evaluate Risk Tolerance, advisors usually ask investors to fill out a short questionnaire about their attitudes toward risk and their willingness to pursue more favorable outcomes at the risk of experiencing less favorable outcomes.  A typical question you might have been asked is, “In a 20% down market, would you: A) Buy more; B) Just hold tight and stay invested; C) Sell some of your portfolio; or D) Sell everything immediately.  But, regardless of how you answered that question and several other similar questions to reach to a score that represents your Risk Tolerance, you also must examine your Risk Capacity.

Risk Capacity encompasses your total financial plan, including your need for income, future withdrawals, investing time horizon, and other financial goals and objectives.  A wealthier investor may have enough assets to allow the portfolio to experience significant market volatility and down markets without endangering the long-term plan.  Though the investor may score high on Risk Tolerance, the investor does not have a need to take on additional risk.  In fact, the investor has a high Risk Capacity, but not a need to accept high risk.

Or, consider an investor who is a pre-retiree and, based on the plan, will have to have ongoing, inflation-adjusted withdrawals of 6.5% of the initial projected portfolio balance.  Though this investor may demonstrate a high Risk Tolerance, he or she has a low Risk Capacity.  Should this investor experience nasty market returns over just a few years, the plan would fail, and significant lifestyle adjustments would become necessary.

Risk Perception, however, is a measure of how risky an investor thinks his or her own behavior might be.  Risk Perception can vary significantly with market volatility, education, and a wide range of behavior biases, but that doesn’t necessarily mean an investor’s Risk Tolerance has changed—it could be just the individual’s perception that varies over time.  The problem is, humans are remarkably poor at judging the risk of their own investment decisions and behaviors, due to a wide range of now well-documented behavioral-financial biases that cause us to misjudge.  The recency bias causes us to ignore the actual risks of our behavior and assume the recent past will continue into the future.  For example, back in the early 2000s, investors just knew that technology stocks were going to go up at 22% per year forever or in 2008 the market is going to drop all the way to zero.  Familiarity bias causes us to assume that things we’re more familiar with are less risky.  This bias can force investors to deny the benefits of diversification.  Availability bias tells us that investors’ lingering perceptions of a dire market environment may be causing them to view investment opportunities through an overly negative lens.

We at The Nalls Sherbakoff Group, LLC, believe there are three fundamental, temperamental qualities that will see investors through the ups and downs of market volatility and are supportive to your financial plan:

  1. Faith in the future.  Faith in our democratic form of government and in our capitalist economic system.
  2. Patience.  Patience in the markets and the reality of market cycles.
  3. Discipline—the capacity to not make inappropriate decisions at inappropriate times; to stay the course.

It is our goal to help you grow in these qualities, and support you where needed.