CFA Level 3 Exam-tips Blog   Private Wealth Management: Risk Tolerance By Dr. Bruce Kuhlman, CFA, CAIA - Level 3 Manager

In a morning case for an individual, you may be asked to determine the individual's ability or willingness to tolerate risk or even determine the individual's overall risk tolerance using the combination of willingness and ability. Here are a few guidelines to help you get full credit:

Willingness to tolerate risk

An individual's willingness to tolerate risk is determined by psychological factors (i.e., subjective factors). For example, the individual might feel their portfolio is large (e.g., perception of wealth). They might feel they are better than others at interpreting market or firm information (e.g., overconfidence). Alternatively, they might want to get on board a rising market (e.g., representativeness, correlating emotions with the market). Other people are just naturally “risk takers.” In other words, the individual may know little or a lot about investing but his or her psychological makeup overrules any attempts at rational expectations (i.e., traditional finance measures).
Statements. In determining willingness, you should look for statements by the individual but you should not rely on them alone. For example, there was a question on a previous Level 3 exam in which the client stated he had average risk tolerance. If you had stopped reading there and determined the client's willingness solely on that statement, you would have missed the individual's history of making risky investments. International equities (especially emerging markets), commodities, derivatives, venture capital, hedge funds, etc, are usually considered risky investments by individuals.

Notice that the individual did not specifically mention willingness to tolerate risk, just risk tolerance. When a client makes statements about risk tolerance, you should interpret the statements as indicators of willingness, not ability, to tolerate risk.

Actions. Always look at what the client does. For example investments as well as other actions in life in general may be better indicators of the client's willingness to tolerate risk. In the previous example the client's actions spoke much louder than his words. The client was a wealthy surgeon and he apparently measured his willingness against his peers. To him he seemed to have average risk tolerance, but to others he would be considered above average.

Ability to Tolerate Risk

The client's ability to tolerate risk is jointly determined by the size of the portfolio (not the client's perception of the size of the portfolio), the client's time horizon, and the client's spending (i.e., liquidity) needs. I sometimes think it's best to think in terms of the portfolio's ability to tolerate risk. Whatever it takes to make yourself do it, you must focus on objective measures in determining ability to tolerate risk.

Rules of thumb:

1. As the size of the portfolio increases → ability increases (positive relationship).
2. As the time horizon increases → ability increases (positive relationship).
3. As liquidity needs increase → ability decreases (negative relationship).

Remember that these spending needs are only those that will be met out of the portfolio return (i.e., met by the portfolio), not the individual's salary or other income.

Another consideration is the size of the spending needs relative to the portfolio. In some cases very large spending needs will be met by a very large portfolio and the result is above average ability. In another case the large spending needs translate to average or even below average ability. For example, if the client must depend upon the portfolio to meet all living expenses it will generally be translated as below average ability. This is the case with retirees.

Overall Risk Tolerance

Willingness. In deciding both the individual's willingness and ability, I always start the individual at average. I then look for reasons to increase or lower. If the individual makes statements about avoiding certain “risky” investments, for example, I reduce their willingness to below average. If on the other hand they say they are not concerned with volatility over the holding period, I increase willingness to above average. Usually a client's specific reference to risk is reason enough to reduce their willingness to below average. If there are no statements one way or the other, I stick with average willingness.

Ability. The final decision on abilityis usually fairly straight forward. Try not to read too much into the question, however. If the client has a multi-million dollar portfolio, a high salary, a long time horizon, and no need to draw on the portfolio for near term spending needs, go with above average ability to tolerate risk. Don't start questioning yourself as to exactly what constitutes a large portfolio or long time horizon. That can only lead to confusion and uncertainty. Go with your “gut.” If given the facts of the case you feel the client's ability to tolerate risk is above average, go with it. If you feel the client has below average ability to tolerate risk, go with that. Indecision on your part can only eat valuable time.

Rules of thumb:

1. If willingness > ability → honor ability → recommend counseling to reconcile the difference.
2. If willingness < ability → honor willingness → recommend counseling to reconcile the difference.
3. If willingness < ability and the client is extremely wealthy → average the two and recommend counseling to reconcile the difference.