The traditional approach to risk tolerance is fairly straightforward – determine how much risk clients can tolerate, and give them a portfolio consistent with that risk tolerance level.
Unfortunately, the problem with this approach is that it can produce a portfolio disconnected from the reality of the client’s goals. Sometimes the portfolio will be more aggressive than it needs to be to achieve the goal. In other situations, a conservative client may end out with a conservative portfolio that will just doom an aggressive goal to failure.
To avoid such mismatches, then, the real key is that risk tolerance should first be applied to the goal itself, and determine whether the goal – and the portfolio necessary to achieve it – is consistent with the client’s risk tolerance. If the “goal risk” is too high, the real solution is not finding a portfolio to achieve the goal, but finding a new goal that isn’t too risky for the client to tolerate in the first place!