If you have
worked with a financial advisor, you are likely to have a good
understanding of risk tolerance, but you may not be as familiar with
important in determining how much risk you should be taking in your
portfolio for your unique financial situation.
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. An investor who can sleep well at night, and not sell investments when the market goes down 30% or more, has a high-risk tolerance; an investor who obsesses over a down market, panics, and sells, has a low-risk tolerance.
Investors with a
higher risk tolerance would typically have a higher percentage of
their portfolio allocated to equities (stocks) and riskier
fixed-income investments, such as high-yield bonds. Even though these
investors are exposed to greater potential loss, they also have the
potential to get higher returns.
Investors with a
lower risk tolerance would typically have a lower percentage of their
portfolio allocated to equities, and a higher percentage in
lower-risk assets such as government treasury bonds and CDs.
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 a very
important factor to consider.
Capacity has to do with the impact a market downturn would
have on your ability to reach your goals. This is different from risk
tolerance, which is about how you feel about risk and how much risk
you are willing to take. Risk capacity is about whether you can
financially afford to take a certain amount of risk.
risk capacity include your time horizon for when you need to tap into
your investments, the withdrawal rate needed from the portfolio, the
length of time you need to draw from the portfolio, the availability
of other assets, and the amount of liquidity needed now and in the
As an example,
consider Jim, who is single and 35 years old, has 30 to 35 years
until he plans retirement, has sufficient liquidity, 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, Jim has a high-risk capacity at this time. Given
his overall financial situation, he 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.
Laura, 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 to 35 years until she
plans retirement just like Jim; 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, Laura has a
low-risk capacity at this time. Given her overall financial
situation, she cannot afford to take on as much risk as Jim in her
portfolio. A major market downturn in the next few years 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.
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 Jim 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 Jim has a high-risk tolerance and is willing to take the
amount of risk indicated by his risk capacity. That is okay too, as
explained above in the analysis of his risk capacity.
Consider Laura –
assume she has a high-risk tolerance and would be willing to take on
more risk than her risk capacity indicates. Just because she feels
she could handle the higher risk, it does not mean she should take
higher risk than her risk capacity indicates, because she cannot
afford to take on more risk at this time.
Risk tolerance is
difficult to quantify since it is based on your emotions and ability
to handle major market downturns. Because risk capacity is based on
your 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 to help determine risk capacity:
need for liquidity increases, risk capacity decreases.
time horizon increases, risk capacity increases.
importance of the investments increases, risk capacity decreases.
Your risk tolerance and your risk capacity may be aligned with one another, or they may not. Both are likely to change over time depending upon where you are in your financial life cycle and depending upon your unique circumstances along the way, which is one reason why a financial plan needs to be monitored and adjusted regularly.
Steven Clark, CFP®, EA
Coconut Creek, FL