Understand Your Clients' Risk Tolerance
The combination of a client's financial risk capacity and emotional risk tolerance forms an overall profile that can be used to determine appropriate investment solutions. --Michael E. Kitces
While risk capacity is all about the financial aspects of a client's ability to sustain risk, risk tolerance (sometimes called risk attitude) measures a client's abstract ability to handle risk emotionally. It evaluates the client's willingness to take on the risk of receiving lower returns in exchange for the possibility of earning higher ones. This pure aspect of a client's risk tolerance has absolutely nothing to do with risk capacity--whether clients have $1,000,000 or only $1 on the balance sheet, some are more willing to seek higher returns at the risk of substantially underperforming goals, while others simply aren't interested in such a trade-off. While risk capacity is about the client's financial ability to sustain underperformance in pursuit of higher return, risk tolerance measures the client's willingness to enter such a trade-off in the first place. The combination of a client's financial risk capacity and emotional risk tolerance forms an overall profile that can be used to determine appropriate investment solutions.
-Michael E. Kitces, director of financial planning for Pinnacle Advisory Group, in Rethinking Risk Tolerance
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