Risk Tolerance

An adviser distinguishes the risk capacity of a client from the risk tolerance of that client. Risk capacity refers to

1. A.the amount of volatility the client says he is emotionally comfortable holding through.Wrong. That is tolerance, an attitude the client reports rather than a fact about his finances.
2. B.the rate of return the client must earn in order to reach the goal on schedule.Wrong. That is required return, which describes what the goal demands rather than what the client can withstand.
3. C.the amount of loss the client can absorb without putting a stated goal out of reach.Correct. It ties the measure to the balance sheet and the goal, which is what makes capacity objective.
4. D.the extent to which the client believes a particular investment is dangerous.Wrong. That is risk perception, which can be corrected with information and is not a limit on anything.

Why: Capacity is a financial fact drawn from the balance sheet, the cash flow and the timing of the goals, and it measures how much loss the client can absorb before a stated objective is put out of reach. Tolerance is an attitude, describing how much volatility the client is willing to live with, and the two frequently disagree. A complete profile records both, together with the return the goals actually require, because a recommendation has to respect the lower of what the client can bear and what the client will bear. Where capacity is low the allocation must reflect that however comfortable the client says he is.

A client instructs her adviser that her religious observance forbids holding instruments that pay interest. In the investment policy statement, that instruction is best recorded as

1. A.an investment objective, since it plainly describes something the client wants from the portfolio.Wrong. It limits what may be held and states no target for return, income or growth.
2. B.a measure of her risk tolerance, since it reduces the opportunity set available to her.Wrong. Narrowing the universe is a limitation, not a statement about her willingness to bear loss.
3. C.a unique circumstance constraint that governs which securities may be selected.Correct. Recording it as a constraint is what makes it implementable and reviewable by any future manager.
4. D.a private matter for the client alone, and therefore outside the policy statement altogether.Wrong. A restriction that is never written down cannot be implemented or monitored by anyone.

Why: An investment policy statement separates objectives, which describe what the portfolio is meant to achieve, from constraints, which describe the boundaries within which it must be achieved. A religious restriction narrows the investable universe without saying anything about the return sought or the loss the client can bear, so it belongs among the unique circumstances that govern security selection. Recording it there makes it operative, because it can then be implemented by the portfolio manager and checked on review. Leaving it out of the document would guarantee that some future manager violates it.

A new client completes the risk tolerance questionnaire of the firm and scores in the most aggressive category. The adviser should treat that score as

1. A.a determination of the appropriate allocation, since the questionnaire exists for that purpose.Wrong. It is an input to the allocation and cannot stand in for the rest of the profile.
2. B.a measure of willingness that must still be reconciled with his financial ability to bear loss.Correct. Attitude and capacity are separate readings, and the binding one governs the allocation.
3. C.evidence of the rate of return this client needs in order to reach his stated goals.Wrong. Required return follows from the goals and the time available, never from an attitude survey.
4. D.conclusive, because the client answered the questions himself and is bound by his answers.Wrong. A duty owed to the client is not discharged by pointing at a form the client completed.

Why: A questionnaire samples attitude, so it produces a reading on willingness to bear loss and nothing more. Willingness has to be reconciled with capacity, which comes from the balance sheet and the timing of the goals, and with the return the goals actually require, before any allocation follows. Where the three disagree, the allocation is constrained by the most binding of them, and an aggressive score cannot override a client who will need the money next year. Treating the score as the answer converts a data-gathering tool into a substitute for the judgement the client is paying for.

A client has just sold the private company that represented most of her net worth and now holds the proceeds in cash. In updating her profile, the change that matters most is that

1. A.her time horizon has shortened, because she no longer receives income from the business.Wrong. Losing an income stream does not move any of her goals closer in time.
2. B.her risk capacity has changed, because one illiquid holding has become diversifiable liquid wealth.Correct. Composition of the balance sheet is what capacity is read from, and it has changed fundamentally.
3. C.her risk tolerance has increased, because the successful sale proved her judgement sound.Wrong. A favourable outcome is not evidence about her willingness to bear a future loss.
4. D.her required return has fallen, because the sale proceeds are now safely in hand.Wrong. Required return is set by her goals and horizon, and the sale changed neither of them.

Why: A life event changes a profile by changing an underlying fact, and here the fact that changed is the composition of the balance sheet. What had been a single illiquid holding, concentrated in one business and correlated with her own labour, is now liquid wealth that can be diversified and drawn on, which raises her capacity to bear market risk in a way nothing else in the profile has done. Her goals, her horizon and the return she needs are all unchanged by the transaction. Whether she should actually use the additional capacity is a separate question, answered by her goals and her tolerance rather than by the sale.