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Marcia Kostner, CFA, is an advisor to individual investors. To determine each of her clients' risk tolerance objectively, Kostner uses a mathematical formula with inputs that include the client's age, family size, insurance coverage, liquidity, income, and net worth. What is the most likely shortcoming of Kostner's approach to assessing risk tolerance?

A This approach does not consider the investor’s attitude toward risk.

When determining an investor's risk tolerance, an advisor should analyze the investor's personal situation, but should also gauge the investor's attitude toward risk. Risk tolerance is affected by the investor's psychological profile (i.e., willingness to take risk) as well as by the investor's ability to take risk. Age is an important influence on risk tolerance; younger investors generally are more able to withstand short-term losses because they have a longer time horizon in which to recover. Investors with high net worth are also more able to withstand short-term losses than investors with lower net worth, and thus tend to be more tolerant of risk.

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