The changing definition of risk

By Mark Yamada | October 15, 2018 | Last updated on October 3, 2023
4 min read
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The know-your-client (KYC) process is meant, in part, to identify an investor’s tolerance for risk. Risk tolerance is an imprecise calculus that tries to measure the balance between fear (the ability to sustain losses before suing the advisor) and greed (the pursuit of gain).

In this context, risk is defined as variability of outcomes (volatility) and absolute loss of capital. Establishing the absolute loss tolerable over a 12-month period is a good way to gauge risk capacity, but advisors know that investor appetite for risk changes with how the market is doing and the urgency investors feel about achieving near-term goals. Risk appetite may be higher after an extended bull market, and higher still when a client realizes she’s not going to reach a goal that’s due mere months from now (like funding a child’s university tuition).

Listing goals by investor priority and demonstrating the potential downside of the portfolio that’s required to achieve each one may be a better way to establish a risk profile than targeting a label of “conservative,” “moderate” or “aggressive.” The most risk-averse investor may change their tolerance when confronted with a priority goal and diminishing time to achieve it. In a goals-based environment, risk is defined as the chance of not achieving the goal.

Success in goals-based investing is defined as delivering on financial objectives. Conventional investment success, institutionally derived, is a portfolio’s ability to beat a benchmark of indexes that represents the investor’s risk profile. For individuals, that risk profile may have little to do with what they want or need, or when they want or need it.

Time creates the most havoc in goals-based portfolio construction. Adding purposes and time horizons leads to multiple risk profiles, as wealth management expert Jean Brunel has argued. But try telling your compliance officer that your client has many different risk profiles.

Brunel holds that institutional risk determination is top down, with a single purpose and time horizon, while individuals “need to look at risk as an aggregation of bottom-up risk profiles.” Brunel suggests identifying:

  • a client’s main goals (including needs, wants, wishes, dreams, fears and concerns);
  • time horizons;
  • related cash flows or bullet payments (a single payment due all at once at some future date);
  • lowest “funding cost” (the cost of providing adequate funds) for each goal.

Taken with an investor’s portfolio, understanding goals and objectives together with flows— including liabilities—allows for a more comprehensive financial picture. Investing for individuals is becoming more about financial planning than picking stocks.

Traditionally, a 60% equity and 40% bond portfolio fit a “moderately risky” KYC risk assessment. Different asset mixes represented by different model portfolios would be available to accommodate clients with different risk tolerances. All goals would be addressed in aggregate by the same asset mix.

In the current approach, each goal should have its own portfolio to address different time horizons, purposes and risk profiles. Because compliance departments still insist portfolio and product suitability be relatively uniform for each client (they’ll permit variations if accompanied by separate KYC questionnaires), these individual portfolios must be aggregated into an overall asset mix. The three goals (A, B and C) are placed into three sub-portfolios (PA, PB and PC), which are then aggregated into a portfolio that acts like a 60:40 mix.

A more efficient way to manage multiple goals and time horizons is to have two portfolios: one for safety, one for growth. Different proportions of the safety and growth portfolios can address each goal, weighting exposure to each portfolio so the risk is balanced in between, or “barbelled.”

We use the term value-at-risk (VaR) for estimating downside for each goal over a one-year period. VaR is a measure of loss over a stipulated period expressed as a probability. The safety portfolio may be built to a risk score of 5, suggesting a five-year investing horizon with the worst return at the end of five years being return of capital plus inflation with a 95% probability. Also, during any 12-month period, there is a 99% likelihood that the worst decline will not exceed 5%.

This approach establishes a return floor under the portfolio that allows for better goals-based planning, particularly for near-term goals. Each goal can be addressed with its own investment solution.

Some advisors may prefer a cash-equivalent safety portfolio. In our example (see Table 1), the asset mix can have an equity component for growth potential and to offset inflation. The return floor is -5% over any 12-month period, assuming market risk remains constant.

A growth portfolio could be a conventional 60:40 portfolio. In this example, fixed income is weighted toward a shorter duration to reflect expected higher interest rates. As long as market risk is stable, these weights work. Asset mix must shift to offset changes in market volatility. If market risk increases, de-risk the asset mix and vice versa. The risk score of 20 indicates a 20-year time horizon with the worst return at the end of 20 years being return of capital plus inflation with a 95% probability. Also, during any 12-month period, there is a 99% likelihood that the worst decline will not exceed 20%.


Investor risk profiles like “conservative,” “moderate” and “aggressive” must be supplemented with information about objectives, priorities and time horizons as goals-based investing becomes more popular. Not reaching a goal on time may be the new definition of risk.

Table 1: Sample safety and growth asset allocations
Asset class Safety (risk score 5) Growth (risk score 20)
International equities 3.5% 20.0%
Canadian equities 5.0% 20.0%
U.S. equities 20.0%
Canadian aggregate bonds 6.5% 18.0%
Short-term bonds 26.5% 22.0%
Floating-rate bonds 57.5%
Cash 1.0%

Mark Yamada is President of PÜR Investing Inc., a software development firm. Disclosure: PÜR Investing Inc. provides risk-based model portfolios to Horizons ETFs.

Mark Yamada headshot

Mark Yamada

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.