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Tell apart how much risk an investor wants to take and how much they can afford to take

CFA® Level I · Portfolio Management · Basics of Portfolio Planning and Construction · PM.10.a

The idea

Risk tolerance has two parts that must be assessed separately. Ability, or capacity, to take risk is objective: it depends on the investor's time horizon, wealth relative to spending needs and liabilities, the stability of income and whether losses would threaten essential goals. Willingness to take risk is psychological, revealed by the investor's own statements, by questionnaires and above all by past behaviour, such as selling in a downturn. The two often conflict. Where willingness exceeds ability, ability governs, because enthusiasm does not create the capacity to absorb losses. Where ability exceeds willingness, the adviser may explain the cost of excessive caution, but should not override the client; if education does not change the client's view, the lower willingness sets the risk level. In practice, then, overall risk tolerance is usually set by whichever of the two is lower.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which factor bears most directly on an investor's ability to take risk?

  1. Enjoying market speculationWhy not: Describes temperament, which is willingness rather than ability.
  2. A long time horizon — correct
  3. A calm reaction to headlinesWhy not: Also psychological; it indicates willingness, not financial capacity.

Ability is about objective circumstances such as horizon, wealth relative to needs and income stability. A long horizon gives time to recover from losses.

A harder one

An investor is eager to take high risk, but her spending needs will absorb most of her portfolio within three years. Her overall risk tolerance is:

  1. below average, set by her ability — correct
  2. above average, set by her attitudeWhy not: Enthusiasm cannot supply the capacity to absorb losses that her near-term needs remove.
  3. average, blending the two viewsWhy not: Conflicts are not averaged; the lower of the two governs.

High willingness, low ability. Because a loss would threaten spending she cannot defer, ability limits the risk, making overall tolerance below average.

The hardest tier

A 35-year-old surgeon with a high, secure income and large savings sold all her equities during the last market fall and says she cannot stand losses. How is her risk tolerance best described?

  1. Below-average ability, above-average willingnessWhy not: Reverses the two: her finances are strong while her behaviour shows aversion.
  2. Above-average ability and willingnessWhy not: Ignores her panic selling, which is the clearest evidence of willingness.
  3. Above-average ability, below-average willingness — correct

Her horizon, income and wealth give her a high ability to bear risk, but her behaviour and statements reveal low willingness, which the adviser should address before setting the allocation.

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