Risk Tolerance in Two Dimensions

Cordell, David M.
May 2002
Journal of Financial Planning;May2002, Vol. 15 Issue 5, p30
Academic Journal
This article discusses how to approach risk tolerance assessment in a way that will improve planning quality and client satisfaction. Assessing client risk tolerance is one of the most important, yet most nebulous, activities for financial planners. Selecting appropriate insurance coverages and determining investment suitability rely heavily on the planner's ability to assess risk tolerance, yet no definitive standard for evaluating risk tolerance has emerged. From a planner's perspective, we can set aside risk propensity and risk knowledge, and analyze risk tolerance in two dimensions: risk attitude and risk capacity. We can dispense with risk propensity because it is essentially encompassed by these two factors--that is, to the extent that risk propensity has any value in evaluating a client's willingness to incur risk, it is a poor surrogate for a direct assessment of risk attitude. Likewise, an analysis of risk capacity implicitly considers risk-related decisions addressed by risk propensity. Similarly, risk knowledge is implicitly incorporated in the two-dimensional model. The client's risk attitude is greatly influenced by an improved understanding of financial risks, sometimes increasing and sometimes decreasing the client's willingness to accept risk. The client's risk knowledge is also reflected in an evaluation of risk capacity because informed clients are better equipped to make decisions that involve risk taking.


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