THE BLOG
06/17/2014 12:58 EDT | Updated 08/17/2014 05:59 EDT

Risk Tolerance Is Nothing to Take Lightly

Every time you sit down with an investment professional, you are asked what your risk tolerance is. Regardless of the method for defining the risk you'll accept in your investment portfolio, you are wise to define the meaning at the outset with the person administering your money. It will save you a lot of sleepless nights.

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Every time you sit down with an investment professional, you are asked what your risk tolerance is.

Despite the commonality of the question, the answers vary wildly because both investment professionals and clients understand something slightly and/or significantly different by the phrase. The subjectivity of the question makes it almost impossible to have a reasonable conversation about it, unless you first have a chat about what, precisely, you are talking about.

Many people think of investment risk as exposure to potential permanent loss of capital, but what many practitioners seek to define for their clients is how much volatility they are comfortable with. Unfortunately, for both the askers and the answerers, neither definition is particularly helpful, not to mention the confusion between which definition is intended.

The first problem is that the vast majority of mainstream investors are not interested in any exposure to permanent loss of capital! So, defining parameters around an acceptable level of this type of risk is as useful as stapling Jell-O to the wall.

The marginally more interesting question sets out to understand what volatility (or variability of returns, plus as well as minus) an investor is willing to accept. That is why many practitioners consider volatility to be the measure of investment portfolio risk. The issue of making risk and volatility synonymous is that no one minds volatility when it goes up!

Also, most investors are subject to emotion. They tend to be more comfortable with volatility and invest more aggressively during stable times and less willing to accept volatility when financial markets become testy. This causes clients to describe their risk tolerance and the allocation of risky assets they are willing to put into their portfolios differently during various parts of the investment cycle. Typically, investors are influenced by their most recent experience of profits or losses. Unfortunately, this is as good as we've got for industry standards, at the moment.

In thinking about this problem, my preference has evolved from asking people to define risk tolerance by ranking possible outcome stories, to a shift in defining risk aversion instead. Risk aversion is a marginal, yet important shift in ideology from the traditional risk tolerance question. Not to split hairs but it specifically isolates the negative impact of volatility in its definition, leaving the positive upswings out of the conversation. Moreover, it is conveniently easier to quantify with mathematical preferences. Instead of asking, "How many years of poor returns are you willing to accept and how reliant you are on these funds for your current income," we can ask a series of questions more like, "Consider a 50/50 gamble where you can lose $10,000. What is the smallest gain, should you win the coin toss, at which you would accept the gamble?"

Regardless of the method for defining the risk you'll accept in your investment portfolio, you are wise to define the meaning at the outset with the person administering your money. It will save you a lot of sleepless nights.

This column should not be construed as investment advice, nor can it take into account your own specific circumstances. The opinions formulated within this article are based on sources believed to be reliable and may not reflect the opinions of any organizations that I am affiliated with.