It is critical for advisors to evaluate both clients’ capacity for and comfort with risk. Once both are assessed together, advisors can use multiple complementary strategies to manage risk dynamically.

R​isk tolerance can be tricky to pin down. An investor may describe it one way during a planning conversation with a financial advisor and feel very differently when the market gets bumpy.

That disconnect between expectations and experience is where real stress can start to show up. At Flexible Plan Investments (FPI), we believe that understanding both a person’s capacity for risk and their comfort with it is key—and that portfolios should be built to reflect both.

Suitability is more than numbers

That mindset isn’t unique to us. A few years ago, financial commentator Michael Kitces hosted a webinar called “Rethinking Risk Tolerance,” where he emphasized the importance of assessing both risk capacity and risk tolerance.

Risk capacity measures what an investor can afford to risk financially, based on their assets, liquidity, income needs, and time horizon. It is essential to determine how much risk a client can absorb given the volatility of the financial markets.

Risk tolerance, on the other hand, is about the client’s emotional ability to endure losses and volatility. Attitude toward risk can determine whether a client can stick with the financial plan once it is developed and deployed.

Understanding both is critical, but what’s revealed in the numbers doesn’t always match how someone feels when faced with real market volatility—and both factors can shift over time.

We’ve built these dual measures into our process. Our suitability questionnaire, developed decades ago, helps advisors assess both capacity and tolerance. It’s also not a one-time event. Through our OnTarget Investing website, investors can review and resubmit their suitability information at any time. They also receive quarterly reminders to reflect on whether their goals or outlook have changed.

A better way to evaluate performance

Suitability should also shape how performance is evaluated. We believe you cannot evaluate a risk-managed portfolio by comparing it only with a market benchmark such as the S&P 500. The S&P 500 is an unmanaged stock index, and it may carry more risk than some investors can tolerate during market corrections. A benchmark can be useful context, but it does not always reflect an investor’s goals, risk tolerance, or time horizon.

To help address that challenge, we developed a methodology for monitoring strategy performance in terms of probabilities.

Our OnTarget Investing process brings that methodology to our clients.

The OnTarget Monitor uses hundreds of Monte Carlo simulations of the client’s portfolio against the strategy’s benchmark. The portfolio value is plotted against a projection of possible investment outcomes over the client’s stated investment time horizon.

It provides a valuable tool for advisors and their clients to evaluate whether a strategy is performing in line with our research. If performance is not in line with expectations, the advisor might recommend portfolio adjustments or a revisiting of the client’s suitability questionnaire.

When the plan doesn’t match the person

Kitces also noted that risk capacity and risk tolerance don’t always line up. For example, two people may both have conservative attitudes toward risk (low risk tolerance), but one might also have a low risk capacity, while the other could financially afford to take on more risk.

Kitces seemed to be saying that to deal with this mismatch, advisors have to help clients “reset” their expectations—though what this really means is adjusting their risk tolerance, which is no small task.

Traditional advice might include educating clients about long-term market returns and the need to “grin and bear it” through short-term volatility. But as many experienced advisors will tell you, that usually requires a lot of reassurance and hand-holding along the way.

We believe there’s another way: Adjust the portfolio instead of asking the client to change.

Most conventional portfolios rely on static asset allocation to manage risk. That provides only one layer of defense—diversification among assets.

In contrast, our actively managed portfolios use multiple complementary strategies to manage risk dynamically. These strategies diversify not only by asset class but also by how they behave in different market environments. Because the strategies are actively managed, the mix of aggressive and defensive positions is continually adjusted in response to changing market conditions—adding a layer of adaptability that static allocation simply can’t provide.

A portfolio’s risk should be less than the sum of its parts

By combining actively managed strategies that respond differently to market environments, our portfolios seek to offer layered protection. Different strategies—trend following, mean reversion, or volatility targeting, for example—can help smooth out the ride. And because these strategies adapt over time, the portfolio can respond more quickly to market shifts.

This dynamic approach may better bridge the gap between what an investor can handle and what they need to achieve their financial goals. In many cases, the result is a portfolio with lower overall risk exposure than any single strategy alone could provide—while still allowing for growth.

This thinking informs the portfolios we offer—designed to help advisors align investors’ strategies with both the plan and the person behind it.

A tradition of aligning portfolios with real people

Risk isn’t just a number—it’s personal. That’s why we believe portfolios should reflect not only market realities but also the individual behind the investment plan. At FPI, we’ve spent decades developing actively managed strategies that adapt to changing conditions while helping investors stay aligned with their goals.

Our focus has always been on delivering investment solutions that go beyond one-size-fits-all advice. And as markets, needs, and investor mindsets continue to evolve, we’ll keep building portfolios designed to do the same.

The opinions expressed in this article are those of the author and the sources cited and do not necessarily represent the views of Proactive Advisor Magazine. This material is presented for educational purposes only.