What is a risk profile?
Traditional finance uses the concepts of classical decision making, modern portfolio theory, and the capital asset pricing model (CAPM) to define the risk profile of an investor. In this model, investors are inherently risk averse and take on additional risk only if they judge that higher anticipated returns will compensate them for it. One of the fundamental results of modern portfolio theory is that, under the assumptions of the CAPM (Sharpe 1964), all investors invest in a combination of the risk-free asset and the market portfolio. The allocation of funds between the risk-free asset and the risky market portfolio is determined only by the risk aversion of the investor. Thus, in the world described by this traditional model, the investor's risk profile is given by the risk aversion factor in the utility function of the investor.
In reality, investors face constraints and do not act according to the model of rationality used in traditional finance (see, for example, Kahnemann 2012). A useful approach to dealing with there practical challenges is to distinguish between risk capacity and risk aversion.
Risk capacity applies to the objective ability of an investor to take on financial risk.
