Investment Portfolio Risk Tolerance and Security Types

Introduction to Risk Tolerance Assessment

It is important for financial planners to evaluate a customer's risk tolerance — the degree of comfort an investor has in taking on risk (Investopedia, 2013). It is not good practice to assume it. The client interview process is the best way to assess risk tolerance, and there are several factors that contribute to it.

From a rational perspective, the client's wealth, current investment holdings, and time horizon all play a role. A younger, wealthier client with a range of sophisticated investments will have a higher risk tolerance than an older client who has little experience investing. The investment knowledge level of the client can also be gauged to some extent through an analysis of the client's existing portfolio.

There are also, however, irrational components to risk aversion that need to be taken into consideration. During the interview process, hypothetical scenarios should be posed to get a sense of the client's reaction. The client should know that these are hypotheticals, so as not to cause unnecessary alarm. By posing scenarios that mirror hypothetical investments and situations, the planner can develop a clearer picture of the client's true comfort with risk.

Types of Equity, Debt, and Mutual Fund Securities

The most common equity securities are common shares, which represent partial ownership in a company. Share returns are based on a combination of dividends and capital gains. However, the risk with shares is that neither of these is guaranteed. As such, there are significant downside risks to share ownership — the value of the shares could remain below what was paid, and they could fall to zero.

There are several common debt securities, including Treasuries and corporate bonds. Treasuries represent borrowing from the U.S. government. They pay low rates of return but are considered to be risk-free. There is some risk, however, in that they may pay a negative real return once inflation is factored in. Corporate bonds — or even other types of government bonds such as municipal bonds — also represent borrowing, but they are riskier because these entities cannot print money as the Treasury can. Thus, other bonds pay higher rates of return than Treasuries, but usually not as much as equities. However, their nominal returns are guaranteed.

Mutual funds are a different category in that they contain a large number of holdings within each fund. The fund is managed for a fee, known as the management expense ratio (MER). Mutual funds can fluctuate in price as equities do, even when they are comprised of bonds. While this creates significant downside risk in theory, mutual funds are diversified in a way that helps reduce it.

Risk Profiles of Bonds, Stocks, and Mutual Funds

Bonds carry two primary types of risk: default risk and interest rate risk. Default risk reflects the possibility that the issuer is unable to pay either the interest or the principal. This form of risk is compensated for through the interest rate — riskier bonds bear higher rates. Interest rate risk is the risk that the value of the bond's future cash flows is reduced by an increase in prevailing interest rates. Expected changes in interest rates are built into the bond price, but any unexpected upward moves will reduce the real value — though not the nominal value — of the bond.

Stocks carry considerably more risk. Equity is subordinated to debt, which means that if a company goes bankrupt, bondholders are paid out first before shareholders receive anything. There is always the risk, therefore, that a shareholder could receive nothing for their shares and lose all of their money. Even a bondholder might recover something — pennies on the dollar — in the event of bankruptcy, but a stockholder receives nothing at all. This risk is only mitigated through diversification (Damodaran, n.d.). There is also the risk for any given stock that it drops below the purchase price and never recovers, forcing the investor to take a loss in order to sell.

This is also the case with mutual funds. While less risky due to their diversified nature, they still function like equities, and there is no guarantee of either distributions or capital gains to mutual fund holders. This is true even for holders of bond funds — something that should be remembered, as bond funds do not carry the same risk profile as individual bonds.

References

Bodie, Z., Kane, A., & Marcus, A. (2010). Essentials of investments: 2011 custom edition (8th ed.). Boston, MA: McGraw-Hill.

Damodaran, A. (n.d.). Risk and return models: Equity and debt. Stern School of Business. Retrieved April 23, 2013, from

Investopedia. (2013). Risk averse. Investopedia. Retrieved April 23, 2013, from http://www.investopedia.com/terms/r/riskaverse.asp