Linking investor and investment risk requires putting the two into the same language; common approaches to doing this are not fit for purpose.There cannot be a perfect empirical way of mapping investor risk to investment risk. You cannot link the long-term risk people prefer with the short-term choices they make.We use indifference curves and an available frontier of different levels of portfolio risk to show where the combinations of long-term risk and reward that an investor is equally happy to accept meet the universe of available investment options.
Risk appetite questionnaires need not be (indeed, should not be) “elaborate”. Over-engineered and superficially sophisticated ‘revealed preference’ approaches result in exactly the same problem for investors as Kids do for investments: highly unstable reflections of current short-term preferences, not long-term needs.Risk tolerance cannot be accurately assessed by putting complex risk-return choices in front of people, or asking them to choose between possible portfolio outcomes in the distant future. As humans, we simply don’t know how to judge the level of risk we’re prepared to take over the long term.If organisations are to ensure they are providing the right level of risk for their clients, they need to stop pretending that it is possible to arrive at accurate measures of risk for individual investments ‘bottom-up’. The more granularly we try to measure risk, the less credible the measures become.