People often describe risk in terms of the investor’s attitude to risk and in determining what investment should be used investors are often steered towards particular investments because they coincide with their attitude to risk.
We wonder, however, exactly what ‘attitude to risk’ means and if it has any great value in the investment process?
We think the answer is that it does NOT because investors are using the wrong measurement and should be using a measurement called risk tolerance rather than risk attitude.
The scale that is applied to attitude of risk is often on the basis of a 1-5 or 1-10 rating, generally 1 being no risk and 5 or 10 being very high risk. In other words the higher up on the level you go, the higher up the indicated risk. So an investor is often asked on these scales to put themselves into a risk category and the question often is what risk level from 1-5 would you put yourself at? 1 being no risk, 5 being high risk and the resulting answer determines exactly where an investor sits on that ladder of risk. Nearly all investors, with very few exceptions, will pitch themselves in or around the middle point and probably just somewhere below it, so most people will say somewhere between 2, 3 or 4 on a 1-5 scale and 4, 5 and 6 on a 1-10 scale, this being that investors are generally saying that they are of the mind to take a bit of risk but overall are interested in security.
The difficulty with this is that is doesn’t really help the investment process because whatever an investor might say about their risk attitude, that is merely an emotional view of their own position. People don’t like to lose money, some people are more philosophical and better able to cope with that emotionally but there are people who cannot abide any form of loss, even if it is part of a wider programme which would result in better returns and their attitude to risk is adjusted accordingly.
The simple fact is that from a financial planning point of view this is a complete contradiction.
The only factor that is relevant is what risk the investor’s finances are able to withstand not what they can emotionally deal with. The financial plan that each investor should work towards must be written on this basis.
This applies to each and very part of the plan and to each and every investment holding. Is the level of risk individually and collectively across the plan affordable?
If the answer is that the level of risk is too great then the outcome is that any investment is not appropriate even if the investor wanted it or not. The converse is also true, if the investor says that he is prepared to take high risks and plants himself for example on level 7 or 8 of the risk scale, based on his attitude, this may be completely inappropriate if this level of risk is completely unnecessary in terms of the financial plan. Risk tolerance is far more important than risk attitude when planning ones finances.
