Risk tolerance, are you tossing and turning at night?

Risk tolerance, are you tossing and turning at night?

Financial markets are oscillating widely. But are all investors losing sleep over their portfolio losses? Not everybody is tossing and turning.

Individuals vary widely in how well they tolerate financial risk. Some investors don't like risk so they stick to investing in low-yielding term deposits while others swear by shares, even if they have been knocked by previous losses. Many people insure their home and contents, but not their life. We all differ in how we manage and protect out finances.

Many people believe that financial risk tolerance varies and is subject to market conditions. However, the evidence suggests that our risk tolerance is an enduring personal trait that is typically set by early adulthood.

Like other aspects of our personality, it is determined by genetics and life experiences. It may decrease slightly with age. It may also change as a result of major life events. Divorces, for example, may reduce one's tolerance for risk (and marriage). But mostly, our risk tolerance is stable. You can read more on this in our white paper, On the Stability of Risk Tolerance.

While some investors (and their advisors) believe risk tolerance changes with major events such as a share-market correction, typically it is an investor's perception of risk that changes, which often results in a change in their behaviour. Buying high (when risks are perceived to be low) and selling low (when risks are perceived to be high) are two typical outcomes for many people.

FinaMetrica decided to assess risk tolerance scientifically. We chose psychometrics as our science, which allows personal traits such as IQ or risk tolerance to be measured in just minutes. We've we learned that:


  • Risk tolerance tends to be stable over an individuals lifetime.

  • Men tend to be more risk tolerant than women.

  • Financial services professionals are more risk tolerant than most of their clients.

  • Despite many contrary opinions risk tolerance tends not to reduce meaningfully with age.

  • In most cases education has little impact on an individuals risk tolerance.

  • If risk tolerance changes its likely to be after a traumatic personal event such as loss of a job, divorce or failure of a business.

  • Risk tolerance, when it changes, may increase, as well as decrease.


As risk tolerance is one of the few aspects of an individual's life that is unlikely to change over time, it's a solid foundation for conversations with investors about risk generally and portfolio risk in particular. This is a far preferable outcome to ignoring risk tolerance or assessing it through questionable means: using astrology (yes, really!), portfolio picker tests, conversation alone or reviewing past behaviour.

To make suitable investment recommendations, advisors also need a proven methodology to manage risk-related factors with clients. The process for determining a suitable investment strategy is called “risk profiling". This involves separately assessing the risk an individual needs to meet their financial goals, their capacity to bear losses and their risk tolerance, so that they can be understood, compared and mismatches resolved.

While there are many more advisors who now follow risk profiling best practices, the majority still operate without full understanding of the state of the art. However, standards are moving toward greater sophistication, which is to the benefit of both investors and their advisors. This can only help boost the public's trust in the financial services industry and advisors. Read more in FinaMetrica’s white paper, Risk Profiling: Art and Science.


Posted: 6/10/2015 4:52:45 PM by Paul Resnik