Risk profiling and asset allocation

Risk capacity is what the client's finances can absorb (job stability, time horizon, dependants, alternative income). Risk tolerance is what the client emotionally accepts (response to drawdowns, sleep-at-night threshold). Asset allocation translates the lower of capacity and tolerance into a portfolio mix. Strategic Allocation is the long-term default; Tactical Allocation is short-term tilts.

A common framework: risk-tolerance questionnaire gives a score (e.g., Conservative, Moderate, Aggressive); convert to allocation ranges (e.g., Conservative 30/70 equity-debt, Aggressive 80/20). Modify based on risk capacity: a 30-year-old with stable income and no debt has high capacity even if low tolerance — but the allocation should follow tolerance, not capacity, to avoid panic-selling. Strategic allocation: 70/30 for a 35-year-old with 25-year horizon. Tactical: temporarily move to 60/40 if equity valuations are extreme. Rebalancing: annually, or when allocation drifts >5% from target.

A nuanced point: the "human capital" angle on asset allocation. A young person's greatest asset is future earnings (human capital), which behaves like a bond (stable cash flows). Therefore, financial assets should be tilted to equity to balance the household total. As retirement approaches, human capital depletes and financial portfolios should shift to debt. This framework justifies aggressive equity for young investors even those with low risk tolerance.