In this post:

  • There’s more to understanding a client’s investment profile than just Risk Tolerance
  • What’s the difference between Risk Tolerance and Loss Aversion?
  • How to measure Risk Tolerance and Loss Aversion

 

There’s more to understanding a client’s investment profile than just Risk Tolerance

Managing risk as an advisor requires understanding each client’s risk preferences. However, common risk profiling approaches in use today often oversimplify risk preferences—there’s quite a bit more to the story.

There are two fundamental preference metrics to understand when pinpointing a client’s risk profile: Risk Tolerance and Loss Aversion.

What is Risk Tolerance?

[1] Benjamin Graham, The Intelligent Investor, Harper Publications, New York, 1949

Risk Tolerance measures the portion of money an investor is willing risk losing for potential gains. Investors who have a higher risk tolerance are more comfortable in portfolios with higher volatility/return profiles. Economists measure Risk Tolerance using a parameter called CARA ρ (constant absolute risk aversion, rho), which calculates a user’s willingness to take investment risk.

What is Loss Aversion?

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