Risk objectives and risk tolerance: ability vs willingness

In short

• Risk objectives specify portfolio risk in line with the client's risk tolerance. They can be absolute (e.g. no more than a 5% loss in a year), relative to a benchmark (e.g. within 3% of an index), or a combination.
• Absolute objectives are made practical as probability statements, e.g. a 95% value at risk. Relative objectives are measured with tracking risk (tracking error), the standard deviation of portfolio minus benchmark returns.
• Liability-driven investing (LDI) sets risk objectives relative to known future obligations, e.g. minimising the chance a pension plan cannot pay benefits.
• Ability to bear risk is objective: time horizon, income, wealth relative to liabilities. Willingness to take risk (risk attitude) is subjective, assessed by discussion or psychometric questionnaires.
• If ability is low but willingness high, assess tolerance as below average. If ability is high but willingness low, counsel the client, but do not try to change their personality. The prudent rule: go with the lower of the two and document it.