What Is Risk Tolerance?

Have you ever been a passenger in a car that was being driven too fast ?

Or in a car that was being driven too slow ?

These questions are about risk tolerance. but physical risk tolerance rather than financial risk tolerance.

Research shows that there are four types of risk tolerance: physical, social, ethical and financial. People behave consistently within type — a hang-glider is more likely to also be a mountaineer — but not between types — a confident public-speaker may or may not be a financial risk-taker. Here the concern is financial risk tolerance.

Research shows financial risk tolerance to be a single general attribute relevant to all financial issues. That is, you do not have one type of risk tolerance when it comes to investing and another when it comes to borrowing, or career choices or any of the many other financial aspects of modern life.

Defining Risk Tolerance

Risk tolerance affects how psychologically receptive an individual is to decisions involving risk. Thus, decision-making theory is a good place to seek a meaning for risk tolerance.

Decision-making involves choosing between alternative courses of action. There is risk in any course of action where there is no certain outcome. Depending on the situation, the possible outcomes (for the alternative courses of action), may be all favourable (a ‘greater good’ choice), all unfavourable (a ‘lesser evil’ choice), or a mix of favourable and unfavourable.

Broadly, risk tolerance can be seen as the sum of all the ‘fear/greed’ trade-offs available, including trade-offs between making the most of opportunities and securing financial well-being, between regret avoidance over ‘losses’ incurred from taking too much risk, and over ‘gains’ missed through not taking enough risk, and so on.

Therefore, risk tolerance is best defined as the extent to which a person chooses to risk experiencing a less favourable outcome in the pursuit of a more favourable outcome*.

It is important to recognize that risk tolerance represents a trade-off on the continuum from minimizing unfavourable outcomes to maximizing favourable outcomes, not just an upper limit on unfavourable outcomes. “Risk preference” would perhaps be a better label for the attribute being described because “tolerance” has implications that risk is always an undiluted negative. However, risk tolerance is the term most commonly used.

Most people accept the universal truth of “nothing ventured, nothing gained.” Risk tolerance is simply a question of where each individual is psychologically comfortable in setting the balance point.

Risk Tolerance and Risk Capacity

Academic and professional financial planning literature recognises two risk-related constructs: risk tolerance and risk capacity .

Risk tolerance. how much risk I choose to take, is a psychological attribute of the individual. Risk capacity. how much risk I can afford to take, is a financial attribute of the individual’s circumstances.

Risk tolerance affects how psychologically receptive an individual is to decisions involving risk, and the degree of anxiety experienced in situations where risk is evident.

Risk capacity is the amount of money an individual could afford to lose without putting the achievement of (financial) goals at risk. It represents an absolute, downside constraint on strategy selection. An individual should not embark on a course of action where the worst case scenario involves the possibility, no matter how remote, of a loss greater than his or her risk capacity.

Risk tolerance and risk capacity both have important, but distinct, roles to play in the financial planning process**. Here, however, we are concerned with risk tolerance.

The Nature of Risk Tolerance

Like many human attributes, an individual’s risk tolerance is thought to be a product of nature — in essence, what is genetically driven, and nurture — what has been experienced. In psychology, it is classed as a psychological trait, i.e. a relatively enduring way one individual differs from another. Risk tolerance is stable but it is not set in concrete. Life events, good and bad, may have an impact and there is a general tendency for it to decrease with age.

Relationships with demographic factors have been extensively studied and some patterns are emerging. In the most authoritative study*** to date, risk tolerance was found to be:

positively correlated with education, income and wealth (as these increase, so does risk tolerance but only slightly) and

negatively correlated with age (as age increases risk tolerance decreases, and at an accelerating rate) and number of dependents (but again only slightly.)

Further, there was quite a large gender difference, with males on average more risk tolerant than females by comparatively about the same as the difference between male and female heights. Finally, marriage decreased risk tolerance marginally.

However, the correlations were all weak or very weak. So, for example, while 60-year olds are on average less risk tolerant than 30-year olds, there is quite a reasonable chance that a particular 60-year old will be more risk tolerant that a particular 30-year old.

Risk Tolerance and Behaviour

Risk tolerance will affect behaviour, but it is only one of a number of factors that collectively will determine what an individual does in a particular situation. Other factors will be the perceived level of risk, the person’s goals, the perceived alternatives and so on.

All other things being equal, most of us prefer to take paths where the risk is consistent with our risk tolerance. But, for example, if we are running late and it is really important to arrive at our destination on time, we may be prepared to go faster than we would normally choose.

However there is very real danger in a situation which you suddenly discover to be far more risky than you’d thought, as happened to many in the recent stock market downturn. Lulled into a false sense of security by smooth travelling of the late 1990s, the bumps came as a very nasty surprise. If you panic, as some did, it can be equivalent to jumping out of a moving car.

It is very important that you understand both the risks and your risk tolerance.

* This is the definition used in the ISO (International Standards Organisation) draft standards for Personal Financial Planning.

** The ISO draft standards for Personal Financial Planning require financial planners to be competent in assessing both the risk tolerance and the risk capacity of their clients.

*** Faff, R.W. McKenzie, M.D. & Hallahan, T.A. (2004). An Empirical Investigation of Personal Financial Risk Tolerance. Financial Services Review, 13, 57 – 78.

View the Faff and Co Paper