Last year I updated everyone on the new software that we have been using from Finametrica to analyze our clients’ risk tolerance. In case you missed it, you can find that article here. We have found this software tool to be very helpful as we try to understand our clients’ attitude towards risk. It is very important for us to understand your risk attitude but there is another very important element to risk and that is risk capacity. Your risk capacity is the amount of risk that you must take on in order to reach your financial goals. There is a balance between risk attitude and risk capacity that we try to find as we come up with an optimal asset allocation for our clients.
It is also important to remember that risk and reward are closely tied together. We know that if we take on more risk with an investment then we need a higher return to justify that risk. When we analyze your risk attitude we are looking at how much risk you are willing to take with your investments. When we analyze your risk capacity we are looking at how much of a reward do we need to justify the risk you are willing to take.
Our goal is to develop an asset allocation that we feel you can be comfortable with but which will also give you the returns you need to achieve your goals. We don’t want our clients to feel they are taking more risk than they are comfortable with, but sometimes it’s necessary to stretch the boundaries of your comfort in order to reach your goals. Sometimes our clients need to decide whether they want to take more risk than they are comfortable with or if they would rather lower some of their financial goals. Typically we see clients adjusting their plan by cutting back on spending or trying to save more.
Understanding our clients’ overall risk profile isn’t always as simple as it might seem. For example, someone who jumps out of planes for a living might have a very high tolerance for risk. But when we look at their risk capacity we might realize they don’t need to take a lot of risk to reach their financial goals. If we looked only at this skydiver’s risk attitude we might suggest an asset allocation that takes on more risk than is necessary. Instead we try to understand all aspects of our clients’ risk profile and then develop an asset allocation that properly reflects this.