Rethinking risk tolerance

Christian Charest: A basic element in determining a portfolio’s asset allocation is understanding the risks that you need to take in order to reach your goals and also understanding not only the amount of risk that you’re willing to take, but also the amount of risk that you’re able to take. With me to talk about these topics is Morningstar Canada’s Director Research, Dr. Paul Kaplan. Thank you for being here.

Now let’s start with making an important distinction. We often hear about the concept of risk tolerance, but you like to think of it in a different way, as risk capacity. Can you please explain the difference between the two terms?

Paul Kaplan: Yes. They're both very important and they both need to be considered in making any kind of investment decision. Risk tolerance is basically your feeling about risk. You can think of it in terms of how well I can sleep at night knowing the risk that my portfolio is subject to. Risk capacity on the other hand is how much risk can I take. So, for example, you might be young, just out of school, just starting your career, your retirement nest egg is still very small. You have your whole career ahead of you. You’re going to be making lot of income in the future, and therefore I've got quite a bit of risk capacity on that tiny little retirement nest egg, because even if I lost it all tomorrow, I still have next week to earn it all back through my salary. On the other hand, you may be a person that really cannot tolerate risk and the thought of losing money just keeps you up at night. So you can see those two can be very different for the same person.

Charest: Now, when you explained the risk capacity, you brought an important topic. People often view risk in a fairly limited way, we tend to look at our economic wealth in terms of our financial assets, but there's another concept that's just as important and that’s human capital. Why don’t you explain what that means?

Kaplan: Yes. Human capital is a very important concept. It was actually first developed by Professor Gary Becker at the University of Chicago, who won a Nobel Prize in Economics, for developing the concept. And what Professor Becker pointed out was that each of us -- you know, we each come into the world with certain capabilities that will help us potentially earn income in the future. This could be just sort of our basic skills, for example, someone may be naturally athletic, so they could become a professional athlete. Another person might be naturally good at foreign languages, so they can become a translator, and so on, so there's sort of some innate ability, and then we can also enhance and build our human capital, particularly in our younger years by our education. This is why many of us will go on to university and from there we might even go on to graduate school, even possibly doing a Doctorate, because in doing so it's making an investment, and so just as you might think of a firm buying updated plant and equipment, so that in the future it could produce more goods they can sell, you as an individual might go for that higher degree in the same spirit to build your human capital. So that you’ll increase your earnings income in the future, your capability to earn income. So, that’s the general concept.

Now, as financial economist, we think about it just a bit narrower than Professor Becker did, in that we think of it in terms of an asset. So, on the one hand you have your financial wealth. You have your portfolio, even in that portfolio you have some funds and stocks and bonds and you might own some real estate and so on. Then look at the human capital side, what do you have in that portfolio? Well, the main thing you have in that portfolio is you have that future income, and if I take that future income and discounted it at some discount rate, it starts to look a lot like a bond. And in fact, there is a Canadian Economist, Moshe Milevsky, who has published a book called, Are You a Stock or a Bond? where he expands on this concept. Are you a Bond would be an example if you are a tenured professor, you teach economics at the University of Toronto. You have tenure, you’re never going to lose your income ever, even if all your students hate you. Okay. That’s a guaranteed income, that’s like you’re owning a bond.

Charest: Fixed income.

Kaplan: It’s the fixed income, and therefore on your financial side, as you are building that retirement nest egg, you can afford to take a lot of risk in that financial nest egg. You can buy a lot of stocks in that retirement nest egg. At least through the first part of your career, because you know that you have that tenured professorship, for pretty much as long as you want it. In contrast, maybe you are a stock broker, and maybe what happens is that your income may be very high when the market is booming, you have a lot of clients, you’re doing a great business and you may be bringing home millions and millions of dollars every year in business. On the other hand, a market crash comes along, the stock market collapses, and you find you're out of a job. So, then you are a stock.

Charest: Yes.

Kaplan: Right. Because now your income is very stock-like. If you have a stock-like human capital, you want to balance that with a bond-like financial capital, if you have a very bond-like human capital, you want to match that with a very stock-like financial capital, and you want that overall asset allocation to be what's relevant for you personally in terms of where you are in your life. What your needs are. And finally what your risk capacity is.

Charest: So valuing the... quantifying the value of that human capital, from what you're explaining sounds a lot like valuing investments. It's very much present value of future payments, with the element of risk in there.

Kaplan: It is a lot like that, and in fact, our colleagues in Morningstar Investment Management, they actually explicitly do this in building their asset allocation models, because this is a very... Morningstar view this as a very important component to figuring out what’s the right asset allocation for any given investor.

Charest: It's a much more holistic approach.

Kaplan: It’s a much more holistic approach. Obviously, one of the most important elements is your age. But in addition to your age, it’s the type of profession you have, it’s the type of education you have, and so on. All this really needs to be considered and when you sit down with a financial advisor and you talk about where should I be in my asset allocation today, these are the kinds of things you need to be discussing. What kind of income do I have in the future based upon my age?

For example, if I'm 65 and I'm thinking about basically retiring, and I'm saying, well, now I'm going to live off of my retirement nest egg, the first question is, is that retirement nest egg even big enough to live the rest of my life? You might easily live for another 30, 40 years with today’s medical technology. Maybe you’ll consider working longer, expand that human capital further, if you don’t have enough financial capital.

Charest: Interesting, interesting points. Thank you very much, Paul, for being here and for explaining all of this to us.

Kaplan: Thank you.