Risk Tolerance, Loss Tolerance, and the Velocity of Wealth

Insights

Individuals and families looking to build and sustain wealth over time need to contend with risk as both a threat and an opportunity. Whether saving for retirement or estate planning, you’ll need to think carefully about the risk of loss as a counterbalance to your potential earnings.

Too often, people’s approach to risk is overly cautious, prioritizing higher floors and lower ceilings at the expense of cheapening the entire proverbial house. For example, investors may pursue compounding interest rather than a more lucrative (if slightly riskier) velocity of wealth strategy. But the stark reality is that a risk-averse approach also limits the potential for growth.

Below, we’ll explain why compounding wealth is a more effective overall philosophy.

Risk Tolerance and Loss Tolerance Approaches to Wealth Management

In wealth management, risk tolerance is a nebulous term that refers to the amount of risk an entity is willing to submit itself to when strategizing investments. The thing that’s hard to pin down about it is that this is tolerance of prospective loss—the possibility that loss will occur, or the likely impact of that loss, represented as a percentage or other figure that’s hypothetical.

Loss tolerance is a bit more straightforward. Rather than dealing in probabilities of a loss occurring, loss tolerance is about real losses that have occurred. It’s a measure of how much actualized loss a particular investor or strategist is willing to suffer before switching strategies.

In both cases, however, risk and loss are framed as negatives to be avoided, mitigated, or addressed strategically. This contrasts heavily with a more aggressive approach: risk appetite.

Risk Tolerance vs. Risk Appetite in Financial Decision-Making

Risk appetite is about accepting rather than avoiding risk. As one ISACA expert puts it, risk appetite and risk tolerance are “two sides of the same coin,” but this side is about taking risks rather than controlling them. This approach also accepts that risks come with potential short- and long-term consequences. But it posits that risk aversion carries its own risks, particularly longer-term ones, as it leaves earnings on the table in pursuit of short-term security.

Put Differently: Risk appetite re-frames risk tolerance’s calculations in positive terms.

Taking on fewer risks typically means putting a higher share of funds into conservative investments like bonds rather than riskier ones like stocks. Risk tolerance would frame this high-floor decision as a security measure, whereas risk appetite views it as a limit on total possible yield. Conversely, risk tolerance would view a higher allocation in stocks as potentially dangerous, whereas risk appetite would highlight the benefits of such a high-ceiling approach.

Risk tolerance can be seen as risk aversion, whereas risk appetite is risk acceptance.

The Good, the Bad, and the Ugly of Compounding Interest

A pillar of risk-averse investing is the “set and forget” approach of investing early and relying on compounding interest to carry a portfolio through regular ups and downs that the market will experience. While there is wisdom in this approach, it’s not always optimal for growth.

To start with the good, compounding interest can lead to substantially greater gains over a prolonged period. A composite from Charles Schwab illustrates the power of compound interest by showing how an individual who invests $10K and lets it grow for 20 years could wind up with about 15% more than a second individual who invests double that amount ($20K) in increments of $2K per year over the course of 10 years. In theory, the slower strategy is significantly better.

But another way of looking at this hypothetical is that the swifter, later investor made up ground surprisingly quickly. In addition, it’s unclear what opportunities the slower investor is leaving on the table that the more velocity-based investor could have been capitalizing on in the ten years their money wasn’t tied up in the same market, earning the same ~6% per year on average.

The bad is that the same factors that make compound interest attractive are the reasons more aggressive, high-transaction schemes can be more effective. The stability of compound interest requires a bigger, earlier investment and much more time to come to fruition. But this gives investors less flexibility to adjust to changing market conditions and other opportunities.

As for the ugly: the slower strategy depends upon stability in the investor’s life and in the broader financial landscape outside of it. In more turbulent times, gains could be erased, or opportunity costs could be so significant that they amount to de facto losses for the family.

Compounding Wealth, Wealth Velocity, and Effective Planning

Rather than relying on compounding interest on investments, savvy financial planners can also target compounding wealth. This strategy generates velocity by making very many strategic adjustments and investments over time, allowing short-term gains to crescendo into bigger windfalls while minimizing opportunity costs and other threats by leveraging smart risks.

Risk appetite is the key to building velocity and compounding wealth. McKinsey has shown how critical risk appetite is to risk management, including mitigating the negative consequences of nonfinancial risks. The biggest risk of all is often not taking any—or not leveraging smart risks.

Build Velocity and Compound Wealth Effectively with Tomoro

The best way to take advantage of smart risks and build a healthy risk appetite is to work with an expert strategist. At Tomoro, we believe in maximizing the performance of your investment holistically by targeting smart risks and optimizing growth rather than minimizing exposure to potentially lucrative opportunities. We’ll help you build, sustain, and share wealth with the people who matter most to you—setting your family up for inter-generational success.

To learn more about how we can help, get in touch today.