September 21, 2017

The Importance of Knowing Your Risk Capacity

If you have worked with a financial advisor, you are likely to have a good understanding of risk tolerance but may not be as familiar with risk capacity.

Both are important in determining how much risk you should be taking in your portfolio for your unique financial situation.

Defining Risk Tolerance and Risk Capacity

Risk Tolerance is a psychological factor – it is all about your behavior and mental attitude. It is related to how well you can handle downturns in the market. As a simple example, if an investor can sleep well at night, not panic, and not sell investments when the market goes down 30% -40% or more, then this investor has a high risk tolerance. If an investor obsesses over a down market and worries about his investments and sells, then this investor has a low risk tolerance.

An investor with a higher risk tolerance would typically have a higher percentage of their portfolio allocated to equities (stocks) and riskier fixed income investments (interest earning) such as high yield bonds. Even though this investor is exposed to greater potential loss, they also have the potential to get higher returns. They are willing to take on more risk for higher potential returns knowing losses could also be higher.

An investor with a lower risk tolerance would typically have a lower percentage of their portfolio allocated to equities. On the fixed income side, they would typically have a higher percentage in lower risk assets such as government treasury bonds and CDs. This investor is accepting lower potential returns so that they might sleep at night and not worry so much about their investments.

Although understanding risk tolerance is important, it should not be the only determining factor in how much risk an investor should take in their portfolio. Risk capacity, as explained below, is also very important and arguably, the most important factor to consider.

Risk Capacity has to do with the impact a market downturn would have on your ability to reach your goals at a certain point in time. This is different from risk tolerance, which is about how you feel about risk and how much you are willing to take. Risk capacity is about whether you can financially afford to take a certain amount of risk with your investments at a particular point in time.

Other factors come into play such as your time horizon for when you need to tap into your investments, the withdrawal rate needed from the portfolio (as a percentage of the portfolio value), the length of time you need to draw from the portfolio, the availability of other assets, and the amount of liquidity (your cash needs) needed now and in the future.

In addition, a person’s entire financial situation must be evaluated in order to determine their overall risk capacity.

Risk Capacity Examples

As an example, consider Investor A who is single and 35 years old, has 30 – 35 years until planned retirement, has sufficient liquidity now, has a stable corporate job in a profession with strong demand, and does not foresee a need to tap into investments prior to retirement. Based on this information, Investor A has a high risk capacity at this time. Given his overall financial situation, Investor A can afford to take on higher risk in his portfolio. A major market downturn would not have any material effect on his financial well-being.

Now consider Investor B who is also 35 years old but her situation is quite different. She owns her own business, supports a family of four, has an unstable job outlook as her business is still struggling to survive, and does not have sufficient liquidity as she puts almost all earnings back into the business. She has 30 – 35 years until planned retirement just like Investor A however; she needs to tap into her portfolio in the next few years to help support her family while building her business. Based on this information, Investor B has a low risk capacity at this time. Given her overall financial situation, Investor B cannot afford to take on higher risk in her portfolio. In the event of a major market downturn in the next few years, the losses in a high risk portfolio could have a negative impact on her family’s financial well-being.

Notice in these examples there is no mention of each investor’s risk tolerance. We have no idea whether they have high or low risk tolerances and we did not need to know this in order to determine their risk capacity.

Combining Risk Tolerance with Risk Capacity

Now that we have an understanding of the risk capacity of our investors, how would risk tolerance be applied to their situations? First, assume Investor A has a low risk tolerance and is not willing to take on the amount of risk his risk capacity indicates he could. That is perfectly okay because he has to be able to sleep at night and not worry about his investments – and it does not affect his financial well-being. Next, assume Investor A has a high risk tolerance and is willing to take on higher risk as indicated by his risk capacity. That is okay too as explained above in the analysis of his risk capacity.

Concerning Investor B, assume she has a high risk tolerance and would be willing to take on more risk than her risk capacity indicates. Just because she could handle the higher risk, it does not mean she should take higher risk. As explained before, she cannot afford to take on higher risk at this time and needs to use her risk capacity as her guide for now.

Summary

Risk tolerance is difficult to quantify since it is based on your emotions and ability to handle major market downturns. Until you actually live through a major market downturn, you may not really know what your risk tolerance truly is. You may think it is high and the results of a risk tolerance questionnaire you complete may indicate it is high, but when an actual market downturn occurs, you may act in a completely different way than you thought you would.

I believe the key to risk tolerance is determining the right amount of risk for your portfolio that helps improve the odds you will stick to your financial plan. If you sell every time there is a down market then you are likely taking on too much risk and you are effectively sabotaging your financial plan every time you sell.

Since risk capacity is based on your goals and measurable things around those goals, it can be more easily quantified. It takes into consideration factors such as your need for cash and liquidity, your investing time horizon, the length of time you need to draw from the portfolio, and your ability to withstand a major market downturn without affecting your goals or harming you financially.

Here are a few rules of thumb to use as a guide around determining risk capacity:

  • When the need for liquidity increases, risk capacity decreases.
  • When the time horizon increases, risk capacity increases.
  • When the importance of the investments increases, risk capacity decreases.

Your risk tolerance and your risk capacity may be the same or they may be different. They are both likely to change over time depending upon where you are in your financial life cycle and depending upon your unique circumstances along the way.

Although they are both important in determining how much risk you should be taking in your portfolio, I believe risk capacity should be the main determining factor followed by risk tolerance.

Please keep in mind, financial planning is a process not an event. A plan needs to be monitored and adjusted regularly as goals and priorities change, as life events occur, and as circumstances change.