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?
 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?