Risk Tolerance: Defining A Misunderstood Term

Sungarden Investment Research Article of the Week

by Rob Isbitts, Sungard Investment Research

First, let’s be clear: “Risk” is the possibility that you will need money but don’t have it, either because your portfolio’s value plunged, because your investments don’t have near-term liquidity, or both. What freaks investors out in the here-and-now, is VOLATILITY. Yet many traditional approaches to building a portfolio don’t really take this into account, other than a token survey question or two when the client is first starting to invest.

Risk tolerance approaches tend to focus on determining the optimal “standard deviation” in returns. That is, how varied returns will be over time. This is an easy way out for the advisory firm! There are more relevant performance statistics to use, that prevent the possibility of oversimplifying the very critical up-front analysis.

Risk tolerance evaluation also does not always account for changes in the client’s disposition as their life evolves, or as market conditions change. In other words, even an “aggressive risk tolerance” investor probably wants to know in advance what their advisor will do if a violent market period ensues.

It is far better to test for a client’s tolerance for volatility, not “risk,” in order to reduce investor anxiety when emotions need to be most in check – like during abnormally difficult market conditions. At Sungarden, we created the Sungarden Volatility Assessment (SVA)™, so the advisor and client understand more specifically what damaging outcomes they will try to avoid – almost like a cardiac stress test as preventive medicine against a potential heart attack. To accomplish this in the resulting portfolio, we monitor the volatility we are taking on, using Beta (a measure of security and portfolio volatility), instead of Standard Deviation (a measure of the variability of returns of a security or portfolio).

One of the things that investors would ask for…if they knew it existed…is something that clearly explains that investment returns are generated by two things: by a combination of a portfolio’s volatility and the skill added (or subtracted) by the portfolio manager’s active efforts. We did that via the creation of the Sungarden Performance ABC™ educational tool.

The end goal is a better-educated client, and a better assessment of what will keep the client in their comfort zone during bad markets, not only good ones.