1) INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #84!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio In today’s episode, we discuss crucial components of investing which are risk tolerance and risk capacity.
Enjoy!
2) HOW MUCH RISK CAN YOU TAKE IN YOUR PORTFOLIO:
François Doyon La Rochelle:
James, this is a topic we have wanted to tackle for a long time. We finally get to it as PWL Capital is launching its new Risk Profiling tool. Risk profiling is a key regulatory requirement to establish suitability for clients’ portfolios. I am sure our Listeners will find this topic very useful. It will help them consider how their portfolio is structured and whether they may need to make adjustments. Let’s get right into it.
James Parkyn:
Francois, we as Portfolio Managers must ensure we implement portfolios that are suitable for our clients. We go through a process of getting to know them that involves asking a lot of questions in a discovery meeting, and then we ask them to complete a Risk Profiling Questionnaire. Armed with all that information, we are then able to develop a Proposed Portfolio that is appropriate to help them reach their goals. I would add, Francois, that I believe this is an important skill that we bring to clients to add value to the relationship.
François Doyon La Rochelle:
I completely agree. So, James, what does Risk Profiling involve? Can you elaborate on the steps you go through?
James Parkyn:
Absolutely, Francois, Risk Profiling has three components that need to be assessed:
An investor’s ability to take risks
An investor’s behavioral loss tolerance
An investor’s need for risk
François Doyon La Rochelle:
OK, James, can you explain the first component: the investor’s ability to take risks?
James Parkyn:
An investor’s ability to take risks includes time horizon, potential need for liquidity, the value of their human capital, and their risk capacity. So, this step involves us assessing the client’s financial ability to handle risk. These factors will determine the investor’s financial ability to withstand declines in portfolio values. The ability to take risks can often be a limiting factor when considering an investor’s need for risk to meet their goals.
François Doyon La Rochelle:
For Time Horizon, the longer you have, the more time you have to recover from the inevitable bear markets. I would add that Retirees can have very long Time Horizons of over 20 years. Even if you retire at 65, your investing journey is likely to still be very long.
James Parkyn:
I agree, Francois, time horizon is a major factor. Especially because you may not want to be overallocated to Bonds. Bonds are the stabilizer or safe bucket in any portfolio. But we know that over the long-term inflation eats away at the real value of Bonds after inflation. We covered this topic on our Podcast on Professor Cederberg’s research about how the so-called safe bucket assets of Bonds will not protect against inflation. Our Listeners can go back to our Podcast # 61 to get his insights.
François Doyon La Rochelle:
James, another element of assessing an investor’s ability to take risks is the value of their human capital. What do you mean by that?
James Parkyn:
Quite simply, Francois, it is the investor's lifetime capacity to earn income from working. Some have very stable cash flows, while others may have less stability. This relates to future capacity to save and build a larger nest egg for retirement. For some investors, the value of their human capital continues well past their retirement, as they continue to earn employment income. This is often a personal preference to continue to work. Research shows that it’s extremely important to do things that make a difference. People like to feel that they matter.
François Doyon La Rochelle:
James, the long-standing belief is that younger investors have more human capital value. Their total future earnings are much larger than their investment portfolio. By contrast, a retired investor who is not working is presumed to have limited human capital value. Human capital can be considered as a bond-like investment, so the high value of a young investor's human capital can justify a higher allocation to stocks.
James Parkyn:
I don’t really agree with this type of thinking, François. When you look at the long-term benefit of compounding returns, if a younger investor loses capital by taking excess risk, particularly if they’re not diversified with their investment plan, then the actual impact of a major loss on their long-term investments could be very large.
François Doyon La Rochelle:
Conversely, James, we have clients over 75 who will never run out of money and therefore have the risk capacity and a risk tolerance to have a riskier portfolio. Their thinking is usually about leaving a larger estate.
Now let’s tackle Risk Capacity. Our practice is to do a detailed balance sheet for clients. This is a great starting point for assessing Risk Capacity.
James Parkyn:
Absolutely, François, I often share with our clients that this is like going to see your family doctor to get a health assessment. The Doctor is likely to suggest doing blood tests, and with the lab results, can give you a lot of feedback. The Personal Balance Sheet for us is like a blood test. We can get a lot of insights to help our clients with this information.
François Doyon La Rochelle:
James, now let’s discuss the second component of a Risk Profile: An Investor’s behavioral loss tolerance.
James Parkyn:
Francois, you know the old saying: “An Investor really learns his risk tolerance in bear markets.” We produce a table that shows our model portfolios and the returns pre-fees over the last 20 years. The worst period was March 2008 to February 2009. In our Table, a standard balanced account of 60% Stock and 40% bonds dropped about 20%, and an assertive portfolio of 80% Stock and 20% bonds went down about 27%. We use this table at Annual review meetings, especially now, as clients have been accustomed to actual returns that are much higher over 10 years than the expected returns. This reflects the three years 2023-2024-2025 that generated double-digit returns in stock markets.
François Doyon La Rochelle:
So, the question is, will you stay the course or sell out? If you fear that you may panic and sell out, then you should reconsider your allocation to stocks. For our listeners, you can find all of this in our Model Portfolios' performance history. A link to this document will be provided with the podcast.
James Parkyn:
This is why it’s so important for us to get this right. Best practice is to use a psychometric tool. As you stated earlier, Francois, at PWL, we have a new questionnaire that is designed to assess a client’s emotional comfort with volatility. It also provides a financial psychology profile.
François Doyon La Rochelle:
The right allocation is the one the investor sticks with for the long term. If, during a bear market, an investor sells out and panics and waits on the sidelines until they are comfortable getting back in, they are at a serious risk of reducing their long-term returns.
The third and final component of Risk Profiling is to assess an Investor’s Need to take risk.
For example, if you’re a multimillionaire and you only need 50k to live off annually, you may not need to take on unnecessary risk. On the other hand, if your assets are limited, you may need to take on more risk to achieve your financial goals.
James Parkyn:
This part of risk profiling really requires we do financial planning. In our practice, the process is to discuss with the client their investment goals. For accumulators, we are trying to estimate the amount of savings required to reach long-term goals for financial independence. For Retirees who are in decumulation mode, we are planning to find a sustainable withdrawal rate. We input the client's balance sheet information and key assumptions. We review the assumptions with the client to make sure they are comfortable with them. Finally, we prepare a Financial Retirement projection using a new software platform called CONQUEST.
François Doyon La Rochelle:
One of the key assumptions that you make in these projections is the expected returns on investments and inflation. Our regular Listeners know that PWL Capital produces twice a year a guide on Financial Planning Assumptions that gives our estimates for Expected Returns. In the report, you can find a matrix table that covers the whole range of portfolio allocations from 100% Bonds, the safest Portfolio, measured by volatility, to 100% in stocks, the riskiest portfolio. We also review the Report with Raymond Kerzerho, who is the lead author. The plan is to have him on the Podcast in July. Listeners can also review our Podcast #79 when we reviewed last year’s estimates for expected returns.
James Parkyn:
Yes, Francois, we can simulate different allocations and the corresponding Expected Returns. These projections are linear, which is not likely in real life. We also produce a Monte Carlo simulation for 1000 scenarios with various sequences of returns that are random.
François Doyon La Rochelle:
James, what should Retirees do for their allocation? The perception is that at retirement, you must reduce the allocation to risky, volatile investments. Does that make sense for everyone?
James Parkyn:
Yes and no, Francois. First off, they should go through the whole process of reassessing their Risk Profile as we have outlined in this Podcast. Most often, clients do not change their Risk Profile at retirement because they require a rate of return that is higher, as they may have 20-30 years ahead of them. A rule of thumb is to always make sure you have 5-10 years of withdrawal coverage with your Bond allocation. This rule allows investors to avoid selling stocks at rock bottom prices after major market declines.
François Doyon La Rochelle:
That’s great advice, James. Now, let’s look at the field of Neuroeconomics, which is developing a lot of research delving into how the brain changes financial decision-making as we age.
James Parkyn:
Yes, Francois, this new research is really insightful. I came across a research paper published by Camelia Kuhnen, who is a Professor of Finance at the University of North Carolina. Her paper addresses how the brain changes across the lifespan.
François Doyon La Rochelle:
For our Listeners, Neuroeconomics is a field that combines insights from neuroscience, psychology, and economics. Research has revealed that financial decisions are shaped by three broad forces: the environment people find themselves in, the experiences they have accumulated, and the biological changes that come with aging.
James Parkyn:
Francois, at the core of Professor Kuhnen’s work is a simple idea: The brain systems that support learning, valuation, and risk assessment are not static. They evolve, and those changes systematically affect our financial behavior.
She highlights that three interacting brain systems play a central role in financial decision-making. One system responds strongly to rewards and positive surprises, encouraging exploration and risk-taking. Another signals potential danger and uncertainty, promoting caution and avoidance. And then a third integrates information, supports learning, and helps regulate emotions to guide strategic choices.
Her research shows these systems allow people to learn from gains and losses, estimate future outcomes, and assign value to financial opportunities. But their functioning depends on age. HER conclusion is that as the brain changes, so does the quality of financial learning — and with it, financial well-being.
François Doyon La Rochelle:
What I find interesting is that aging affects the brain’s ability to learn from experience, particularly in environments that require updating beliefs about uncertain outcomes — exactly the kind of environments investors face.
James Parkyn:
Among her major findings is that older adults perform just as well as younger adults on tasks that do not require learning from feedback. But when decisions depend on tracking outcomes over time — such as figuring out which investments are paying off — performance declines. She states this is not because older adults are less intelligent or less careful, but because the neural systems that encode feedback become noisier.
François Doyon La Rochelle:
In practical terms, this means that older investors are more likely to make mistakes involving misunderstandings about which financial options are truly better. Professor Kuhnen believes these mistakes are more often risk-seeking errors rather than excessive conservatism, challenging the common belief that aging automatically leads to lower risk tolerance.
James Parkyn:
Francois, this is significant for risk profiling assessments we do for clients. I quote her from her article: “The underlying issue is that the brain’s reward system becomes less precise at tracking outcomes. Signals that once clearly distinguished good from bad investments grow harder to interpret. Over time, this makes it more difficult to learn from market feedback.”
François Doyon La Rochelle:
James's research also shows that while learning clearly changes with age, preferences themselves are more stable than many assume. What can you add to that?
James Parkyn:
Well, Francois, she states that “Evidence on age-related changes in risk tolerance is mixed. Some studies find that financial risk-taking declines later in life; others find little change. It all depends on how risk is measured and whether life-cycle factors — such as income needs or portfolio constraints — are taken into account. Her research suggests that observed portfolio choices often reflect circumstances rather than deep shifts in preferences.
François Doyon La Rochelle:
Another of Professor Kuhnen’s findings is very useful. Where age does matter significantly is trust. Older adults are more likely to perceive others as trustworthy, even when cues suggest otherwise. She states that “At the neural level, warning signals that normally trigger caution in risky social situations are muted. This helps explain why older adults are disproportionately targeted — and victimized — by financial fraud.”
James Parkyn:
This is a major consequential age-related finding. I quote her: “Fraud susceptibility is not simply about education or vigilance. It reflects changes in how the brain processes social risk.”
François Doyon La Rochelle:
It’s not all bad news about aging. She also believes that it would be a mistake to conclude that aging simply degrades financial decision-making.
James Parkyn:
Yes, her research conclusions are more nuanced. She also concludes that many older adults do not exhibit the typical learning deficits. She states that older adults often outperform younger ones in managing emotions, avoiding sunk-cost traps, and maintaining discipline during stressful situations.
François Doyon La Rochelle:
In summary, James, we can say that the key insight from her research in neuroeconomics is not that older adults are “bad decision-makers,” but that they learn differently and respond differently to information. Financial advice that ignores this reality risks being ineffective — or worse, harmful.
James, where does Investing experience come into play when doing Risk profiling?
James Parkyn:
Well, Francois, the more experience an Investor has with Capital markets, the more they are likely to understand that uncertainty is not a bug but a feature. They will have lived through so many bear markets that they learn to tune out the noise. Loss aversion is a very powerful emotion. For many people, uncertainty is something to avoid at all costs. David Booth of Dimensional wrote a great article back in July 2024 on the Value of Uncertainty. I quote him: “Since we know risk is unavoidable- and it’s the source of investment returns – you want to find the amount of risk that is right for you.”
François Doyon La Rochelle:
That is a great quote, James. Investors need to remember that Markets have prospered despite the dot.com bubble, the terrorist attacks on 911, the Global Financial crisis in 2008-2009, and the Pandemic. However, the key to navigating through these difficult periods of the market is to have a plan that properly reflects your risk profile. On that, I think we can conclude today’s podcast, James.
James Parkyn:
Well said, Francois.
3) CONCLUSION
François Doyon La Rochelle:
Thank you, James Parkyn for sharing your thoughts and expertise again today.
James Parkyn:
You are welcome, François.
François Doyon La Rochelle:
So, that’s it for episode #84 of Capital Topics!
Do not forget, if you would like to submit questions or suggestions for the show, please email us at: capitaltopics@pwlcapital.com
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Again, thank you for tuning in and please join us for our next episode to be released on March 18th . In the meantime, make sure to consult the Capital Topics website for our latest blog posts.
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