Subjective and objective risk tolerance: Implications for optimal portfolios. Financial Counseling and Planning

The distinction between subjective and objective risk tolerance is illustrated by expected utility analyses of portfolios. Optimal portfolios were derived for one, 5, and 20 year investment horizons for 6 major financial asset categories. The important aspects of objective risk tolerance are the proportion of an investor's total wealth (including human wealth) in financial assets, and the investment horizon. Even investors with very low subjective risk tolerance levels should have aggressive portfolios if their horizons are 20 years or more. Key Words: Risk tolerance, Portfolios, Investment In investing for long term goals, the allocation of asset categories in the portfolio is one of the most crucial decisions. Most people are not willing to take above average risks to obtain above average returns on their investments (Avery & Elliehausen, 1986). It is likely that many investors focus too much on short term volatility, especially for investing for retirement. Many financial planners stress the concept of the client’s risk tolerance, and give questionnaires to assess risk tolerance. Malkiel (1996, p. 401) stated that “The risks you can afford to take depend on your total financial situation, including the types and sources of your income exclusive of investment income. ” This article proposes that risk tolerance be into two parts: subjective risk tolerance based on the economic concept of risk aversion, and objective risk tolerance, based on Malkiel’s idea of the objective financial situation of the household, including the investment horizon for each goal. The expected utility of alternative portfolios is calculated. Optimal portfolios for various combinations of objective and subjective risk tolerance are identified