Weekend Reading: Kitces: The Big Problem with 'Risk Tolerance'

This article appears as part of Casey Weade's Weekend Reading for Retirees series. Every Friday, Casey highlights four hand-picked articles on trending retirement topics and delivers them straight to your email inbox. Get on the list here.
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Weekend Reading

Retirement portfolio risk is a complex topic, and one of my favorite financial experts, Michael Kitces, is revealing why.


A risk revelation: Beyond risk capacity, Kitces noted that all investors have a “risk attitude” and “risk perception.” Your risk attitude is related to your willingness to take risk in a down market, while risk perception is related to your knowledge about investments. Both components should come together and align with your risk capacity (financial capacity to take risk), in the development of your retirement plan.

Client case study: Kitces utilized an example of two clients to show why the traditional method of pinpointing risk amount in a portfolio is flawed. Typically, this is where advisors look at risk capacity alone, taking into consideration time horizon, need for income and availability of additional assets.

In one scenario, a male investor with a high capacity for risk needs income in 15 years. In the other, a female investor with a low capacity for risk needs income in a year. An advisor pinpoints their risk capacity and nothing else. If something bad happens, the female investor is doomed, but Kitces also revealed beyond that, both individuals are conservative investors, and would end up in portfolios that don’t truly mirror their full risk capacity and attitude.

Full scope: To truly understand the right level of risk to take in your retirement plan, Kitces advised your risk attitude should be measured separately from your risk capacity via your financial planner. As for your risk perception, it shifts over time and must also be accounted for through ongoing discussions with your advisor.

Bottom line: When creating a comprehensive retirement plan, your financial advisor should manage risk expectations and perception from the get-go. This is why our team utilizes a strategic questionnaire to help pinpoint your risk number, and also why we spend time discussing it in-depth too.