Determining an Investor's Willingness and Ability to take Risk
On Individual Investment Policy Statement (IPS) questions the CFA L3 exam is virtually guaranteed to ask you to identify whether an investor has average, below average, or above average ability or willingness to take risk.
This will come in the context of a long passage filled with details about that specific investor--their financial assets, their needs and desires, and their attitude and outlook.
So you need to identify their risk tolerance and justify that answer based on a few pieces of information.
Willingness vs. Ability to take Risk
Ability and willingness to take risk are different.
Think of ability as a quantitative assessment of how much an investor can afford to lose relative to their goals. In other words ability is about how much wealth you have relative to your spending needs.
The lower your standard of living risk the higher your ability to take risk. Generally this correlates to being wealthier--the more assets you have or the higher your current income the higher your ability to take on additional risk. The other main area here is about time horizon. The longer your time horizon the more risk you can take as the more time you have to overcome any short term losses.
Willingness is about your attitude towards risk. It is a more subjective assessment of an investor’s mental attitude towards investing. This is where our investor classification models come in handy.
If there is a conflict between an investor's ability to take risk and their willingness to take risk always go for the most conservative option.
Factors affecting your ability/willingness to take risk
Main Factors affecting ability to take risk:
- Measure of Wealth: > Wealth, > Ability to take Risk. Also subjective, partly depends on investor’s perception of their wealth relative to needs
- Time Horizon/Stage of Life: The longer your time horizon (the younger you are) the greater your ability to take risk
- Importance of Goals: Critical goals (like meeting essential spending needs) indicates a lower ability to take risk whereas things like luxury spending
- Ability to withstand portfolio losses: The larger the shortfall an investor can tolerate before jeopardizing their goals the greater their ability to take risk. Note that the relativity of goals can also equate to degrees of flexibility (bigger or smaller ranges for your asset allocation).
Just a quick recap of the factors affecting ability to take a risk: Measure of wealth, the more wealth the greater the ability to take a risk. This is subjective, right? It's not just absolute wealth, it's also the investor's perception of their wealth relative to their needs. The standard of living risk, time horizon or stage of life, the longer your time horizon the greater your ability to take a risk. All else equal, the importance of your goals, so if they're really critical, you've lower ability to take risk, you really need that money but things are like luxury spending or bequest to future generation those are things that could slip a little bit, so you might have a higher ability to take risk. And then finally, an ability to withstand portfolio losses is instrumental
Main factor affecting willingness to take risk:
- Source of Wealth: Entrepreneurial or active wealth creation (> willingness to take risk) versus passive inheritance (< willingness to take risk)
See the Barnwell 2-way model.
How to identify greater ability to take risk
Generally an investor has a greater ability to take risk if he or she:
- Is younger and has a longer time horizon to recover from losses
- Has more human capital (more potential to earn money in the future)
- Has a large asset base relative to liquidity needs
- Will receive an inheritance in the future
- Has stable income (bond like income versus equity-like income)
- Expects a pension in the future that will cover a high percentage of living expenses
- Has extra income above and beyond expenses to contribute towards building investment portfolio
- Has no dependents
- Is not planning to leave an estate
- Is planning on significant charitable contributions (these can always be canceled if necessary)
- Is debt free
How to identify lower willingness to take risk
An investor has a lower willingness to take risk if he or she:
- Has (or wants) a portfolio with mostly cash or short-term bonds
- Has had a bad past experience with investing, i.e. suffered heavy investment losses
- Is explicit about wanting to avoid loss or maintain the real value of the portfolio
- Owns their own business (high risk concentration already)
- Will retire early
- Already knows they have enough assets to cover all of their needs
These problems are vital and virtually guaranteed to show up on the CFA Level 3 exam in the morning section. Once you've handled the identification and justification using details from the passage you'll be ready to look at the return objective and solve for required return.