How to assess volatility risk

It should be extremely difficult to use your attitude towards volatility to construct a portfolio. This is because volatility cannot relate portfolio structure to financial needs and it cannot relate to the actual risk and return opportunities in the markets.

In fact, your financial demands on your portfolio should have the greatest bearing on the allocation of the portfolio between low risk assets and equities.

Secondly, it is your aversion to significant risks (or liability risks) and your wish for greater short term financial security against these risks that will determine whether or not you need more low risk investments in your portfolio.

Additionally, because there is direct relationship between your financial needs and the structure of your equity portfolio to meet these needs, the basic risk/return profile of your equity portfolio is more or less determined by your financial needs; the amount in small/medium/large companies, high yielding, growth or defensive stocks, overseas and emerging markets.

As such, assessment of your attitude to volatility is primarily an educational exercise over the risks of investment and how the investment manager manages these risks. This assessment depends on your understanding of the following.

That volatility is a simple, understandable and natural phenomenon!
That the risk of volatility reduces over time.
That volatility is not a measure of how much risk your portfolio is exposed to any one point in time but a guide as to the type of the price movements you will see over time.
That higher volatility does not always equal higher return; it can just as likely equal higher risk of loss.
That within a portfolio designed to manage liability risks that volatility should not be a risk to your financial security.
That volatility is not always a sign of how aggressive a portfolio is. A portfolio invested heavily in overseas markets, with a focus on under valued as well as smaller companies can have a much lower level of volatility than the domestic market, yet its allocation will be aggressively invested.
What your attitude is to significant stock market and economic risks. Your attitude to these risks is more likely to define the type of investor you are than your attitude to volatility.
That your assessment of your ability to take the performance risk of the manager’s investment style will have more of a bearing on the risk of the equity portfolio that is selected for you.
That the discipline and structure of the wealth manager is critical to ensuring that the portfolio you are allocated is in keeping with your attitudes to risk.

The volatility of each individual investment within the recommended portfolio and the volatility of portfolio should be provided to the investor and the risks these signify explained. It is at this point that the investor should be given the opportunity to select a lower risk equity portfolio, if need, or alternatively a higher risk portfolio.

It is also important the information regarding the volatility of the portfolio also be backed up by an asset allocation profile and a valuation analysis, to give a full assessment of current risks and how aggressive or conservative the underlying strategy actually is.

In the end, much depends on the advisor's explanation of the risks and rewards of their investment style and how this affects the risk/return profile of the portfolio over time. Much also depends on the manager's investment discipline and their ability to construct, plan and manage portfolios appropriate to the individual investor's financial needs and risk preferences.

The risk assessment process should be primarily an education process and an opportunity for the investor to make adjustments to the recommended portfolio that more closely mirrors their risk preferences. But this cannot be done without the expertise of the advisor in assessing risk preferences.