How can you figure out a client’s appetite for risk? First off, it’s important to recognize that investors often have different risk levels for different investment objectives, says University of Chicago professor Richard Thaler.

One recent factor driving people’s rising comfort with financial risk is the safety net created by several years of positive returns. Thaler has found that, like gamblers, investors tend to take more risks when they feel they’re ahead of the game.

In experiments, some people were given $30 and others given nothing. The first group, Thaler observed, gambled more often when offered the chance to flip a coin for $9 than those who were risking their own hard-earned money.

Emotions can also cause inves-tors to react in strange ways when times eventually turn tough, because they think they should “do something” to protect themselves from the perceived risks. Establishing strict risk guidelines far in advance will help the newly apprehensive folks stay disciplined when the markets are volatile, says Thaler.

The key is to gauge and budget investors’ appetite efficiently for risk, says James H. Gilkeson, a professor at the University of Central Florida.

Risk budgeting is an optimization exercise adopted by many institutional investors that limits the extent to which a portfolio can deviate from a benchmark, he explains. The objective is maximizing expected alpha (the return in excess of a benchmark index) while not exceeding a predetermined acceptable tracking error — the pattern of variation from that benchmark.

PROCESS CAN BE ADAPTED

Gilkeson says the process can be adapted for use by individual investors and advisors who are willing to employ indexing strategies but who are still looking to enhance returns in some fashion. For them, the risk-budgeting process has three components: how much risk is my portfolio taking; is it an appropriate amount; and where should I allocate my risk allowance as I go forward?

First, he suggests, investors must choose a passive, long-term benchmark portfolio. They then must have good cause to deviate from that benchmark, such as a tactical modification because of current economic or investment conditions, or because they believe they can select superior investments or managers within an asset class.

The next step is to determine current risk exposures. Once advisors have developed the ability to measure the risk of each of their strategies, clients can be guided through the budgeting process by using the risk measure as the denominator of the risk-adjusted return equation.

Like traditional indexing, the emphasis here is still on portfolio diversification and asset-class exposures. There is also an attempt to minimize transaction costs and turnover while trying to maximize tax efficiency. Such an enhanced approach, however, requires the sacrifice of tracking to get there.

Following this approach, the client and the advisor determine what will be the maximum acceptable tracking error. Excess return opportunities are identified and a portfolio is built that deviates from the benchmark by a clear margin.

Risk budgeting is related to but not the same thing as the “value at risk” methodology commonly used by institutional investors, says Gilkeson.

VAR is all about the odds of losing money. By assuming investors care about the likelihood of a really big loss, VAR tries to answer such questions as “What is my worst-case scenario?” and “How much could I lose in a really bad month?”

Essentially, the VAR strategy has three elements: a relatively high level of confidence, typically 95% to 99%; a time period, such as a day, month or year; and an estimate of investment loss, which is expressed either in dollar or percentage terms.

The effective use of risk budgeting requires an acknowledgement that not all VAR calculations are the same and that market-risk VAR does not cover the larger galaxy of risks that a portfolio may face.

It’s important that all portfolios being budgeted using a risk amount in such a manner adopt a consistent methodology for measuring risk, cautions Gilkeson. IE