The Illusion that More Conservative Portfolios Address Risk Capacity Issues

The Illusion that More Conservative Portfolios Address Risk Capacity Issues

Academy of Financial Services

October 2012

Abstract

The current evolution of “suitability assessment” of investment portfolios has differentiated between risk tolerance, a psychological construct; risk required, a financial construct of the return required to achieve specified goals; and risk capacity, the risk that the investor can afford in the event of a downturn. Application is usually for advisors to recommend more conservative portfolios if the risk capacity of the investor is deemed to be less than the risk tolerance and risk required. The intent of this paper is to demonstrate that this intuitively correct action, the belief that by reducing the volatility of the portfolio to reduce downside exposure will correct problems of insufficient risk capacity, is the wrong course of action for most clients. Dialogue focuses on the downside reduction without accounting for the trade-off or loss of upside contribution towards achieving the client goals. Clients are not being properly informed of the cost of these decisions.

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