More risk doesn’t always equal chance of better return

An important part of any investor’s approach to making portfolio decisions is the degree to which the investor will expose himself to risk. It is generally agreed that if one expects to make higher returns, one must accept a little more risk.

I will point out that the reverse is not necessarily true. Simply taking more risk provides no assurance that good returns will follow. In fact, taking more risk increases the odds that bad returns will follow. Folks get this point mixed up all the time.

Part of the basic fabric of investing is the notion that the investor must, on their own or with an adviser, determine their so-called risk tolerance. Advisers are trained to ask some questions about a client, and investors can fill out questionnaires on brokerage and mutual fund Web sites. The questions make inquiry into how the investor might feel about portfolio losses and how long their horizon is and so on.

The product of the questioning process is some sort of score that states the investor’s risk tolerance. One person will have a high risk tolerance, another will have a lower tolerance.

The adviser or investor then divides the portfolio into proportions of safe and risky assets - like bonds and stocks - until the blend matches the risk tolerance of the investor.

This approach is fundamentally and irretrievably flawed. The amount of risk that is appropriate for any investor cannot and should not be boiled down into some sort of psychological litmus test. At the very least, the question regarding how much risk is appropriate should be broken into two separate pieces, and I can think of a few more in addition to the two I’ll discuss here today.

The first component of risk analysis is the traditional, psychological one. People are wired differently. Some cannot stomach the idea of owning assets whose value is unpredictable. Others cringe at the notion of owning anything with which they are not familiar, such as foreign stocks or commodities. Another type of person seeks out the unfamiliar and shrugs off short-term gyrations.

These risk appetites really have nothing to do with the investors’ respective financial situations. It is really just a matter of what makes them tick and what will or will not keep them awake at night.

This version of risk appetite is rightly called the risk tolerance. How much uncertainty and discomfort is the investor prepared to tolerate?

The second classification of risk that I like to examine is the capacity for risk. The capacity for risk is quite distinct from the tolerance for it. Some investors, by virtue of their personal circumstances, are in a position to take more risk. Others are not in a position to do so.

For example, a person entering retirement with a multi-million dollar portfolio and a modest lifestyle might have the financial capacity to take risk. If one or two of the investments in a diversified portfolio go bad, the investor might not be happy about it, but at least she won’t be broke.

Conversely, another investor entering retirement with a modest portfolio that will just barely cover her expected living expenses is not in a position to take much risk. While she might convince me that she is perfectly ready to tolerate a lot of risk, I will probably talk her down out of that tree.

The tolerance for risk and the capacity for risk are separate things and need to be reconciled. Sometimes, they match up nicely and those who want risk can afford to take it, and those who don’t want it shouldn’t take it. Yet, equally often, I see mismatches.

Even after reconciling the tolerance and capacity for risk, our analysis still needs to consider other factors. One is the simple question, why bother? If somebody has deep financial resources and the willingness to take risk, it does not automatically follow that they should take much risk.