Given a combination of specific level (average, below average and above average) of ability and willingness to take risk, is there any specific guideline in determining the OVERALL risk tolerance of an individual investor???
Major factors that contribute to risk tolerance: Investmement time horizon and Asset Base.
Longterm investment horizon >15 years, and low liquidity needs in percentage terms <7-8% make you very risk tolerant, because you may absorb a lot of volatility of the markets, without eating into the principal.
The books don’t provide exact numbers, they always state something like: “from medium to high, from low to medium, or low or high”. Someone wealthy and 20+ years investment horizon is clearly has high risk tolerance. Someone who requires his investment income to cover expenses is low to medium risk tolerant, depending on the asset base.
This is very intuitive.
Thanks… But, what will be the answer of these combinations: 1. Above average ability to take risk + Below average willingness to take risk = ___???___ level of risk tolerance??? 2. Above average ability to take risk + Average willingness to take risk = ___???___ level of risk tolerance??? 3. Average ability to take risk + Below average willingness to take risk = ___???___ level of risk tolerance??? 4. Below average ability to take risk + Average willingness to take risk = ___???___ level of risk tolerance???
If there is a mismatch between:
a) ability to take risk (higher) and willingness to take risk (lower)
Then willingness always dominates and go with willingness.
b) ability to take risk (lower) and willingness to take risk (high)
Then ability always dominated and go with ability
I agree with petersimmons80, the lower between ability and willigness dominates.
^Agreed. Go with the more conservative of the two.
^+1
They net out, with willingness generally overriding ability, unless willingness > ability, then go with ability. For example:
Above average ability + average willingness = Average tolerance - go with willingness (overrides)
Above average ability + below average willingnes = Average tolerance - netting & meeting in the middle. This may include some client education on risk…could depend on whether cognitive or emotional biases are responsible for the disconnect between ability and willingness. If emotional, harder to correct, and may end up being below average tolerance. Not positive about this one…
Average ability + above average willingness = average tolerance
Below average ability + average/above average willingness = below average tolerance
Regardless of how much risk you’re willing to take, you can’t if you’re unable. Think underfunded pension of a poorly performing sponsor.
If anyone disagrees or sees something wrong with this outline, please do tell.
Major things can determine the ability to take risk:
-Age
-Investable assets
-Income vs Expenses
-Debt outstanding if any compared to investable assets
-Lawsuits?
-College expenses for kids
Willingness is kind of linked to personal preferance:
-Look at the return objective they mention in the text given; it’s always willing to take risk for high return or looking for conservative investment to provide for their retirement. If they combine both then its average.