Risk Objectives

An example of an absolute risk objective would be that the client does not want to lose more than 5% of her capital over a particular period.

Relative risk objectives relate risk to a certain benchmark that represents an appropriate level of risk.

Risk tolerance is a function of BOTH:

• a client's ability to take risk, as well as,
• her willingness to take risk.

Ability to take risk

The ability to take risk is a function of several factors including:

• time horizon,
• expected income, and 
• net worth.

Generally speaking, a client with a longer time horizon, high expected income and greater net worth has a greater ability to bear risk.

Willingness to take risk

A client's willingness to bear risk, on the other hand, is based on more subjective factors including 

• her psychological makeup and 
• level of understanding of financial markets.

4 scenarios:

1.  Ability to take risk - below average.  Willingness to take risk - below average

The investor's overall risk tolerance is below average

2.  Ability to take risk - above average.  Willingness to take risk - above average

The investor's overall risk tolerance is above average

3.  Ability to take risk - below average.  Willingness to take risk - above average

The investor's overall risk tolerance is below average

4.  Ability to take risk - above average.  Willingness to take risk - below average

The investment manager should explain the conflict and implications to the client.

When there is a mismatch between a client's ability and willingness to take risk, the prudent approach is to conclude that the client's tolerance for risk is the lower of the two factors.

Any decisions made must be documented.