How We Consider Risk
Among the inputs used to determine the advice we provide is the process of evaluating the risk profile of the individual or family we are serving. It is among the principal inputs considered when making recommendations and providing advice. Unfortunately, the process of risk evaluation among firms in our industry is often rudimentary and deficient. In an effort to be transparent and to demonstrate the consideration we grant to this important factor; we are sharing our thoughts on risk evaluation.
Risk Preference – a personal willingness to accept uncertainty and the possibility of a negative outcome in pursuit of a positive outcome.
Risk Perception – an individual’s rational or irrational belief about the probability of an occurrence of a risk and/or about the extent, severity, and timing of its effects.
An individual’s risk preference is subjective and dependent upon their perception of risk, which in turn is dependent upon their expectations, which in turn is dependent upon their education, familiarity, and experience in such matters.
We attempt to assess your risk preference even though it is subjective, variable, dependent upon your environment, and a representation of an abstract psychological trait. Both quantitative and qualitative expressions of risk are considered, but the final determination is based upon the entirety of our interactions and conversations and is qualitative in nature.
Our goal is to educate, familiarize, and establish proper expectations in an effort to normalize client’s perceptions and therefore, to some degree, normalize our assessments. We recognize that any measurement is momentary and as life circumstances change, so will your risk preference. Your circumstances and risk preference are periodically probed during the normal course of our relationship in order to make any necessary adjustments.
Risk Tolerance is a function of one’s Risk Preference and Risk Capacity.
Risk Capacity – the risk a person can assume without concern their goals will be affected if investment outcomes are unfavorable, or alternatively, an amount a person can afford to lose without impact to their goals.
Funding Level – total account balance divided by the required funding level necessary to meet personal goals. If a person’s Funding Level is 200% you may have Risk Capacity.
Risk Required – the amount of risk required to be taken to meet personal goals. If the Risk Required is greater than an individual’s Risk Tolerance, then goals may have to be re-considered
Time Horizon – the amount of time an individual can accumulate assets before requiring those assets to provide for their lifestyle.
Risk Tolerance and Risk Preference are personal psychological sensitivities to risk, whereas Risk Capacity, Risk Required, Funding Level, and Time Horizon are determinable mathematical realities of a person’s circumstances.
Risk Tolerance, Risk Required, Risk Capacity, Funding Level, and Time Horizon are all considered when assessing your risk profile. The ultimate goal being a balance between the risk you want to take, the risk you need to take, and the risk you can afford to take.
In wealth management it is not always what you do for clients that is valuable, but what you don’t do that may be even more valuable. We prefer to inform you of the practices we DO NOT DO in an effort to highlight some really poor practices in our industry and be more transparent. We also invite you to please continue to read our thoughts concerning the two pillars of wealth management: financial planning and investment management.