Risk and Risk Assessment

Recent Headline – “Risk assessment tools inadequate, study finds.”

The implication in the article is that clients are poorly served unless their advisor can adequately define their risk profile.  I suppose that is theoretically true, but there are some missing parts.

Like, what do you mean by risk assessment?

First notice that risk is essentially a state of mind.  What is risky for me may be riskless for someone else.  What I fear may be an opportunity for another.  What I do not understand is automatically risky.  What changes quickly is more risky than something stable.

Next notice that my risk profile today may be different than it was a month ago.  Something scary or soothing may have happened in the interim.  If my advisor were to try to assess it at a point in time, would it always be true?

Lastly notice that risk is a loose term.  Perhaps we should assess risk with some adjectives attached.  Is permanent loss logically different than temporary loss.  If variable risk means unpredictable, is that the same thing as a catastrophic risk.  Should a market correction of 90-day duration be treated the same as a tsunami destroying Tokyo?

Each of us has a risk profile and there may be no objective way to define that profile.  Even the client would have difficulty defining it for themselves.

In the past, I have seen apparently risk tolerant people have problems with small losses over short periods.  They were risk tolerant up to the point where they could lose some money.  That is not risk tolerant.  They are merely misinformed about how markets work.  If WalMart stock falls 10% today, does that say anything about the intrinsic value of the business.  Not really.  It does say a lot about how emotional people react to news, but that should not be risk.  How do you build that into a profile.

Risk and risk profile must be made up of several factors.

Permanent loss is a risk we care about, temporary or transient losses have an emotional effect but they are psychological, not real.  The way we think matters.  Ignorance is not blissful.

The probability of such permanent loss.  Loss and probability together yield an expected value.  You can manage those by comparing to expected value gains calculated the same way.

The exposure to risk.  There are two parts.  What is it and what should it be?  People take bigger risks by avoiding long-term investments and thus transient losses.  Time frame matters.  Long-term, the stock market outperforms the fixed income market.  There is a price to variability avoidance.  About half again more capital.

The capacity to lose matters.  If someone with $10 million has a permanent loss of $1,000,000, they will care but not change much about their life.  The same loss for someone starting with $1,000,000 will be a bigger problem and that exposure should be managed differently.

Tolerance for risk is again a mind thing.  I have noticed though that the sum of experience and risk tolerance remains constant.  Young people think they are bulletproof.  Old people not so much.  Again it is about understanding.  You tolerate things you understand, you fear things you do not.

Risk profiles should include external risk assessment, the client’s perception of that, an inventory of knowledge and skill to mitigate the risks, capacity to absorb a loss, exposure to risk in other areas of life, and education to fill the holes.

There is no free lunch.  A wise client is a good client.

Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Contact: don@moneyfyi.com  

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