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Wealth Management · Topic lesson

Risk Profiling

How an advisor decides how much risk a client should take: what the plan can afford against what the client can stand, what a loss costs to get back, and how the horizon changes the answer.

3 chapters About 34 minutes0 of 3 complete
Start chapter 1

"How much risk should this client take?" is three questions. How big a loss can the plan absorb before essential spending is at risk, and how big a loss can the client watch without selling? What does a loss of that size cost to get back, in gains and in years, with and without withdrawals? And how does the time until the money is needed change all of it? Interviewers ask each with numbers, and this lesson answers each with the arithmetic advisors use.

Two ideas from the old lesson survive here in numbers. The arithmetic average of returns is not what the money earned: after −50% and +50% the portfolio is down 25%, and the geometric average says so. And a portfolio the client abandons in a drawdown fails even if it was optimal, which is why tolerance is a real limit and not a weakness to be argued away.

  • Capacity and tolerance. The floor of essential spending, capacity above it, the client's stated limit, and a stress test that turns each into an equity weight.
  • Recovery. The gain a loss needs, the years it takes, what withdrawals do, and the largest fall a horizon allows.
  • Horizon. The probability of a loss over T years, the bad-case average, the years a limit needs, and what a long horizon does not fix.
The rule that solves every question

Convert every limit into an equity weight through a stress test, and take the tighter one. A loss the plan can absorb, a loss the client can stand, a fall the recovery horizon allows: each divided by how far equities fall with bonds flat is a maximum equity weight, and the recommendation is the smallest of them. The horizon chapter says when that weight can be higher, and why the caveats matter.

Setting a client's risk, in three questions

Each step points to the chapter that practices it.

  1. 1
    What can the plan afford?

    The floor, and capacity above it.

    Chapter 1
  2. 2
    What can the client stand?

    Tolerance, and the stress that converts it.

    Chapter 1
  3. 3
    What does a loss cost?

    Gain needed, years, withdrawals.

    Chapter 2
  4. 4
    How long is the money invested?

    P(loss) over T years; the bad case.

    Chapter 3
  5. 5
    Set the weight

    The tightest limit ÷ the crash.

    Chapter 1Chapter 2

Chapters

1

What the plan can afford and the client can stand

11 min

Two different questions hide inside 'how much risk?': how big a loss the plan can absorb before essential spending is at risk, and how big a loss the client can watch. The tighter one sets the limit.

  • Compute a stress loss and test it against the client's tolerance
  • Price the floor of essential spending and derive risk capacity
  • Turn each limit into a maximum equity weight and take the smaller
  • Say what to tell a client whose tolerance and capacity disagree
2

What a loss costs to get back

11 min

Fall 20% and you need 25% to get back; fall 50% and you need 100%. Turn that into years, and then add withdrawals, which make it far worse.

  • Compute the gain a loss needs, and why it grows faster than the loss
  • Turn a recovery into years at a steady return
  • Show what withdrawals do to the recovery
  • Find the largest fall a recovery horizon allows, and scale it to a mix
3

How the horizon changes the answer

12 min

Equities are risky over a year and much less risky over twenty, not because the bad years stop but because they get averaged with good ones. It is a statement about averages, and the caveats matter.

  • Compute the probability of a loss over one year and over T years
  • Find the bad-case average return over a horizon
  • Solve for the horizon a probability limit needs
  • Say what a long horizon does and does not reduce