Experts can easily define investment risk: It’s the standard deviation of expected returns. For real people, that translates to “Huh?” It might help a bit if rephrased in terms of “volatility,” or if we say something like “the extent of potential variations,” etc. Better still, let’s think of this in terms of what kind of people might choose various levels of risk tolerance.
Let’s look at three investors each facing different circumstances and each choosing a different level of Risk Tolerance.
- Carl from the Condo Clubhouse, a retiree who chooses Risk 1
- Melanie the Millennial, a recent college grad who chooses Risk 5
- Al and Alice Average, a mainstream couple who choose Risk 3
But the world is a complicated place with variations on just about any theme. We’ll also consider:
- Sarah, another retiree for who Risk 5 can be appropriate
- Mike, another Millennial but one who rightly sticks with Risk 1
Finally, we summarize the overall principles (human principles, not quant jargon) of risk tolerance by examining:
- The Risk Assessment Notes (Cheat Sheet) used by the financial planner with who Al and Alice Average meet, a set of notes that reminds him of the general issues he should explore with his clients.
- A primer the financial planner read (on Portfolio123.com!) to help him explain to Al and Alice why the return-risk tradeoff is real and why they cannot expect a free lunch (high return with low risk).