The error popup you are seeing is caused by FSO and not by Knossos.
The reason you see it whenever you select a build is that when you do that, Knossos automatically retrieves the global flags that that build supports, which in turn requires running FSO with a special -get_flags flag. Apparently, even when FSO runs in the -get_flags mode, the code that validates your FSO preferences path still runs, hence this error popup.
AFAIK there is no way to choose a custom FSO preferences path. This preferences folder is for storing your engine config (graphics etc.), save games, and other engine-related logs/data. It's completely separate from the path that Knossos uses for its own preferences.
Unfortunately, the only way around this issue may be to create a separate Windows user account whose name has only ASCII characters in it (that is, only English letters) and use that for Knossos/FSO-based games.
I wonder if the FSO GitHub issues page includes an issue for this.