Painting a Fuller Picture of Risk

The vast majority of advisors, including those at Tableaux Wealth, present new clients with what’s called a risk questionnaire. This survey (which is used to comply with securities regulation) usually asks about the client’s comfort level with volatility in their investments, asking them to pick a number from 1 to 10 to indicate how aggressively their portfolio should be invested on average.  

While the answer can be helpful to the advisor, it’s really not the best first question to ask about risk. More important, it merely scratches the surface of the very large and deep subject of investment risk.  

And yet we really should explore this question because a good conversation with your advisor about risk can truly open the door to a deeper understanding of what motivates, scares, or gratifies you. This in turn can lead to better planning and clearer communication with your advisor. 

Don’t let them put you in a box.

(Image created with ChatGPT.)

Looking at Risk from Three Angles   

Many people think of investment risk simply as how aggressively a portfolio is invested. There is a widespread and simplistic notion that risk equals investment aggressiveness, and that younger investors should take “more risk” by investing mainly in stocks while those approaching retirement should take “less risk” by investing more heavily in bonds.  

But risk has many dimensions. A decade ago, financial advisor and Ph. D in finance Nick Carr developed a framework known as the “7 Dimensions of Risk” that has gained notice among financial advisors. I think it’s helpful to collapse some of those categories and think about risk from three different angles: 1) risk tolerance, 2) risk capacity and need, and 3) risk behavior. 

Risk tolerance is close to what the standard risk questionnaire measures: how comfortable a client thinks or feels she is when it comes to taking risks with her money. As I’ve said, this is important, but on its own it tells the advisor nothing about the client’s actual capacity or need for risk, or how the client has reacted to historic market dips, or even how well the client fully appreciates what risk certain investments pose.  

Meanwhile, risk capacity refers to how conservatively or aggressively a portfolio can be invested while still having a good probability of succeeding. In other words, risk capacity measures what you can afford to lose. Someone with enough assets saved for retirement may be able to invest a portion of their portfolio in “riskier” investments (to create potentially greater long-term wealth for heirs or charities). Even if the market tanks, their financial goals will still be met. A client who may naturally be conservative with money may benefit from some coaxing and reassurance to let that “extra” money earn more money.  

The other side of that coin is risk need, or how much investment risk must be taken in order to reach a particular financial goal. Although a cookie-cutter investment guideline might direct X% of your portfolio to bonds, it might be necessary from a planning perspective to invest a larger percentage in higher-growth securities to increase the likelihood of being able to support a desired retirement lifestyle. Very conservative investments might help protect you in a market disruption, but you would miss out on market gains and portfolio growth to, say, comfortably retire when you would like. A portfolio based only on risk tolerance—and not a comprehensive financial plan—could in this case easily leave you in the lurch a decade down the line. 

Last, risk behavior concerns an investor’s actual behavior, how they feel under certain circumstances, and what kinds of risks they may be drawn to. Someone who is objectively “risky” in one aspect of their lives (engaging in dangerous hobbies, or marrying impulsively) might actually be quite conservative with her money. Someone who is calm, cool, and collected at work might become a nervous nelly every time the stock market gyrates; he might need frequent reassurances that everything is going to be OK and that his financial plan is designed to absorb those market shocks. Good conversations about risk might include a pre-mortem— walking through a hypothetical worst-case scenario to stress-test your financial plan and, as necessary, making changes. 

I’ll add that good conversations about risk often should explore areas outside of investments and include questions like, “what are you afraid of losing that isn’t money?”  Or, “what is a risk you regret not having taken?”  Questions like these can help get at the root of how we each approach money and life.   

In such conversations about risk, your advisor might also touch on another dimension of risk that Carr calls “risk literacy.” While risk capacity measures how much risk a person can afford to take, risk literacy measures whether he fully appreciates the risk he is taking with his portfolio. For example, through conversation and analysis of the numbers, one investor might seem suited, temperamentally and financially, to a particular investment regimen. But if she can’t explain, say, what a 25% drawdown would feel like or what an “88% probability of success” means, then she doesn’t really understand the investment risk she’s taking.  Risk literacy can be improved by an advisor who acts as an educator, not just a presenter of numbers. Most people don’t think in terms of probabilistic outcomes. And anyway, it’s conversation—not numbers—that can build confidence and trust in your financial plan and your advisor. 

Risk is part of life and personal finance. The job of a financial advisor is not to eliminate risk but to manage and prepare clients for risk, based on their financial situation and relationship with risk. That job is certainly not accomplished by a questionnaire or an algorithm based on assets, income, and age.