Making Sense of Risk Tolerance, Risk Appetite

Definitions of risk tolerance can border on the absurd, showing a slavish adoption of financial terminology where it makes no sense.

The degree of risk tolerance, whether at the individual or organizational level, describes whether you are relatively:
1) risk-averse (risk avoiding) in exchange for a degree of certainty regarding the reward in question; or
2) risk-seeking, (accepting of risk) in exchange for the chance of higher gains.
These orientations towards uncertainty can be expressed quantitatively and qualitatively.

For example, financial advisors attempt to gauge an individual’s “investor profile” (tolerance for risk) in two aspects:
a) mental attitude towards risk (converted to a level) using a questionnaire; and
b) financial position, using a calculator.

Similarly, investment fund managers:
a) describe the strategy of a fund as relatively aggressive (risk-seeking) or conservative (risk-averse); and
b) have internal limits (risk appetite) dictating how much capital they will risk.

Therefore, risk tolerance might be articulated by: 1. a general characterization of attitude or philosophy, based on goals and values; and 2. corresponding measures of degrees of resource allocation and investment.

Levels of investment against anticipated return are controllable. Here, corporate statements of risk tolerance and appetite as specific numbers make sense. But translating risk tolerance to non-financial domains is sometimes done literally and inappropriately. Because of the rhetoric, health care and other public sector agencies feel pressured to define a positive number indicating, absurdly,  “tolerance” for children at risk, wait-listed patients, or traffic deaths. Some want to assign a dollar value to human life. Then again, declaring “zero tolerance” implies a strict attitude to abhor and punish one or another social ill, but, of course, cannot confer unlimited capacity to prevent it.

Policy is made through a (hopefully fair) process of representations, reconciliations, checks and balances, in multi-stakeholder political and administrative processes — all reflecting particular values and culture. For this reason, “tolerance” enters into the discussion at several points, and there is no need to make absolute statements of (especially quantified) risk tolerance at a grand level where it is unrealistic. The degree of risk tolerated for any particular decision is reflected in the risk assessment for that administrative context.

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