Have you ever repeated the same word so many times that it no longer conveys any meaning? This is a fascinating phenomenon called semantic satiation, which has even been used with stutterers to reduce the intensity of negative emotions triggered when speaking.1 In the investment world, though, a more banal example of a word that has lost its full meaning presents itself: risk.
Have we done a disservice to our understanding of “risk” by discussing it so much? After the dramatic fall and surprising rebound of stock markets in March 2020, what does the word “risk” even mean now?
In finance, we broadly define risk as the chance an investment’s actual return will differ from its expected return.2 Traditionally, we use volatility to express this variance, and we construct client portfolios based on the degree of volatility clients feel they can stomach.
But is that telling us enough about what level of risk we should assume for the future? For example, does volatility cover the potential permanent loss of hard-earned savings? Did it cover the emotions and sleepless nights that crept up on investors during the global financial crisis of 2008?
We are forever thinking about the fact that it is precisely investors’ ability to tolerate uncertainty that grants us the opportunity to earn a future return. But how can we best quantify risk when managing our savings?
An investor’s risk profile has historically been qualified and quantified using the concept of risk tolerance and assessed via the ubiquitous risk-tolerance questionnaire. It turns out, however, that an investor’s risk tolerance can be rather mercurial.
Starting in 2022, you will hear more from us about the changing and varied definitions of risk. In addition to the traditional risk tolerance that all our clients are familiar with, we will also be discussing and quantifying “risk capacity.”
Risk tolerance and risk capacity can be thought of as two pillars supporting the tabletop of investor risk profile.
The first pillar, risk tolerance, is our willingness to accept risk.3 It is a psychological metric, influenced by our beliefs, our experiences, even our biology.4 It lives in our gut, unleashing our emotions upon us with every twist of the market. We are attempting to measure risk tolerance when we ask questions like “How much can you stand to see your portfolio value decline before you are badly shaken?”
Although education and consideration of investor time horizon can refine our assessment of risk tolerance, in practice, it can be an unreliable metric. Attitudes toward risk can change with age, recent market events, life experience, even our immediate environment.5 Increased risk-taking behavior is observed, for example, in drivers who feel aggravated by congested traffic.6
Given the inherently cyclical nature of capital markets, where does this leave us? If risk tolerance can fluctuate with any number of factors beyond our control, what other tools exist to help us chart the amount of investment risk we should assume.
Enter the second pillar of the risk profile: risk capacity.
Risk capacity is the degree of loss investors can afford to sustain in their portfolios without impacting their ability to fulfill financial obligations. Where risk tolerance is about willingness to endure a potential financial loss, risk capacity concerns ability.7
Such ability is a function of the investor balance sheet. When the balance sheet is tied to a meaningful financial plan, risk capacity assessments can help round out the risk picture. Instead of simply asking how big a drop you can stomach before you’re ready to jump ship, we can frame the assessment within the context of real-life goals.
Risk capacity questions might ask: Considering your current financial position, how big a loss can you sustain before you can no longer fund your children’s education? Until you must delay retirement? Before you sustain a downgrade in lifestyle? Such questions ground the risk picture in factors much more concrete than our emotional response to volatility.
The word risk appears 40 times in this article. If repeating any word too often causes us to disconnect from its meaning, then it’s not surprising that the very act of defining risk and measuring it presents a challenge.
Hopefully, by extending our framework for quantifying risk — and the vocabulary surrounding it — we are better able to understand the risks investors are taking and deliver the returns we need to impact the very tangible outcomes of our financial lives.
1 “Semantic Satiation.” Wikipedia, Wikimedia Foundation, 29 April 2021, available at Semantic satiation — Wikipedia.
2 “Risk.” Investopedia, available at Risk Definition (investopedia.com).
3 The Ontario Securities Commission. “Reforms to Enhance the Client-Registrant Relationship (Client Focused Reforms).” Supplement to the OSC Bulletin, Volume 42, Issue 40 (Supp-1), October 3, 2019, available at ni_20191003_31-103_reforms-enhance-client-registrant-relationship.pdf (osc.ca).
4 CFA Institute. “Risk Tolerance and Circumstances,” March 2018, available at Risk Tolerance and Circumstances (cfainstitute.org).
6 McDonald S. “Risk & Road Rage: Why Driver Safety is More Than Just Skill,” Thinking Driver, February 25, 2013, available at https://www.thinkingdriver.com/blog/news/risk-road-rage-why-driver-safety-is-more-than-just-skill.
7 FinaMetrica. “What Is Risk Tolerance and Why Do We Measure It?,”available at Risk Profiling — FinaMetrica: Home of Risk Tolerance Testing, accessed December 9, 2021.
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