Sizing Up Risk

Recently a headline in Financial Planning magazine caught my eye: “Testosterone May Affect Financial Risk Aversion.” A number of studies have shown women are more risk averse than men when it comes to making financial decisions, but this article detailed new research from Northwestern University and the University of Chicago that suggests a biological basis for this gender difference. Specifically, researchers found that higher levels of testosterone were associated with a greater appetite for risk in women, but not in men. However, in men and women with similar levels of testosterone, the gender difference in risk aversion disappeared. You can read more about the study “Gender differences in financial risk aversion and career choices are affected by Testosterone,” published in the Proceedings of the National Academy of Sciences, by clicking on the title of the study above. I noticed the headline because I’ve been doing a lot of thinking about whether the recession has altered our perception of risk and how best to define and manage each client’s risk tolerance.

Measuring risk tolerance begins, of course, by defining three risks investors need to tolerate. First, there’s market risk, the possibility that events in financial markets may decrease the value of your investment. Second, investors in bonds and bond funds are also subject to interest rate risk. Interest rates and bond prices generally move in opposite directions: when interest rates go up, bond prices go down, and when interest rates go down, bond prices go up. Finally, it may sometimes seem safest to preserve your money by investing in bank certificates of deposit, but they may expose you to inflation risk. That is, if the rate of inflation outpaces your interest rate, you’ll have diminished purchasing power.

In the simplest terms, tolerance for risk measures your willingness to chance loss in pursuit of gain. Recently, in Pamela J. Black’s article, “The Three Faces of Risk,” I found one of the best descriptions of risk tolerance I’ve ever seen. She writes, “Have you ever been a passenger in a car when the driver seems to be going either very fast or very slow? The speed obviously feels right to the driver, but you’re uncomfortable. Either you’re anxious that there will be an accident or you’re wondering why the driver is just creeping along. Many factors determine a person’s driving behavior, but a key element is the person’s tolerance for risk. The fast driver has a higher risk tolerance than the worried passenger does and the slow driver’s risk tolerance is lower than yours.”

Black also offers a wonderful example to illustrate another factor I work to carefully pinpoint – your capacity to withstand a negative outcome. She writes, “Imagine that your 75 year-old mother decides to go skateboarding. You try to talk her out of it because while she may have the appropriate risk tolerance for it—after all, she wants to do it—she doesn’t have the appropriate risk capacity. That is, a fall at her age could lead to a broken hip or some other incapacitating injury. So you give the skateboard to your eight year-old son instead. He doesn’t want to try it because his friends have had accidents and he doesn’t want to get hurt. This would be the opposite situation. He has the risk capacity because his reaction time and coordination are as strong as his young bones and he will recover quickly from any injury. But he doesn’t have the tolerance, the psychological inclination, to take this type of risk.” You can read the entire article by clicking on the title, “The Three Faces of Risk.”

As Black’s examples suggest, risk tolerance is a complex psychological trait that is difficult to measure accurately with a standardized test. Even so, some advisors administer a quick questionnaire to identify clients as aggressive, moderate, or conservative risk takers and invest them in corresponding portfolios behind “Door Number 1, 2, or 3.” My problem with this approach solely is that not only do these questionnaires gauge only the relationship between risk and reward (without factoring in a client’s ability to deal with short-term market volatility) but individuals are placed in generic portfolios.

Three inter-related factors inform your risk tolerance.

How much risk you decide to take generally involves assessing three inter-related factors:

Future goals: Rather than think of risk tolerance as progressing along a matrix, and coming to rest at a fixed number akin to a handicap, it’s important to accept that multiple, sometimes competing goals inform your risk tolerance. For instance, you need to reconcile your immediate need to have money set aside for college tuition with your long-term goal of funding retirement.

Age and time horizon: Think back to the skateboard example. Whereas investors in their 30s may greet market declines as a buying opportunity, those in their 70s may view a down market as a serious threat to their retirement income stream.

Where and who you are: Among other factors, your current net-worth, job security, future earning potential, even your natural temperament combine to determine how much volatility your portfolio could weather. For example, in Chancing It: Why We Take Risks (Little Brown & Co., 1985), Ralph Keyes differentiates between “sprinter” and “marathon” risk takers. Entrepreneurs tend to be sprinters, energized by the rush of new ideas. Marathoners are more comfortable shouldering long-term risks, such as working to strengthen a family business.

While the spectrum of risk tolerance is vast, all investors seem to be bound by a similar thread. They embrace risk when the market is on an upswing, and recoil from it when the market is down. Accordingly, in a bull market advisors often find themselves working to convince clients that there are risks to consider other than the risk of not investing fast enough to get in on the spectacular returns. In a bear market, we sometimes must work to coax money off the sidelines by noting the “Catch 22” inherent in the risk and return equation. That is, while Merriam-Webster’s Collegiate Dictionary defines risk as “possible loss or injury,” risk also is present in opportunities that will be lost if risk is totally avoided.

In conclusion, harkening back to the car imagery Pamela Black uses to describe risk tolerance, you can count on me to assess your risk tolerance and to structure your portfolio with the goal of ensuring that you enjoy the journey and arrive safely at your destination.

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