Category Archives: Financial Planning

2020 Second Quarter Investment Market Report

This year, investors have been treated to a rare real-world lesson in the mathematics of investing—namely, the fact that after a market decline, it takes a greater market recovery to get back to even.  The first quarter saw a frightening downturn that delivered 20% losses across the U.S. and developed foreign markets.  Then we experienced a breathtaking 20% gain in the second quarter, the fourth-best quarterly rise since 1950.  Work out the mathematics, and virtually all indices are still showing a loss for the year.

You can see this dynamic everywhere you look.  The Wilshire 5000 Total Market Index—the broadest measure of U.S. stocks—fell 20.70% in the first three months of the year, then gained 22.69% in the ensuing quarter.  By the mathematics of the market, investors in the index are still down 2.88% so far this year.  The comparable Russell 3000 index is down 3.48% in the first half of 2020. 

Looking at large cap stocks, the Wilshire U.S. Large Cap index lost 19.88% in the first quarter, gained 21.64% in the second, and is still down 2.29% for the first half of the year.  The Russell 1000 large-cap index now stands at a 2.81% loss, while the widely-quoted S&P 500 index of large company stocks gained 19.95% in the second quarter after a 20% drop in the first quarter–and is now down 4.04% for calendar 2020.

Meanwhile, the Russell Midcap Index is down 11.21% in the first half of 2020.

As measured by the Wilshire U.S. Small-Cap index, investors in smaller companies were hit with a very significant 31.40% decline in the first quarter, and then recovered 25.63% in the second.  The index is down 13.82% for the year.  The comparable Russell 2000 Small-Cap Index is down 12.98% so far this year.  The technology-heavy Nasdaq Composite Index recovered from its -13.10% first quarter return to post a 31.61% gain in the second quarter.  The index is one of the few unadulterated bright spots for the first half of 2020, up 10.05% for the year.

International investors experienced the same lurching investment ride as U.S. stock holders, but with a shallower recovery.  The broad-based EAFE index of companies in developed foreign economies lost 23.43% in the first quarter, then gained back 14.17% in the second quarter.  Add it up, and the index is returning negative 12.59% so far this year.  In aggregate, European stocks gained 14.33% in the second quarter, but because they were down 24.81% in the first part of the year, they’re still sitting on a 14.03% loss for the first half of the year.  EAFE’s Far East Index meanwhile, gained 10.82% in the second quarter, but for the year it’s in losing territory, down 9.29%.  Emerging market stocks of less developed countries, as represented by the EAFE EM index, gained 17.27% in the most recent quarter, making up some of the 23.87% losses in the first three months of the year.  The index is down 10.73% for the year.

Looking over the other investment categories, real estate, as measured by the Wilshire U.S. REIT index, posted a 25.63% decline during the year’s first quarter, and then saw a nice 10.56% rebound in the second.  Real estate investors are still down 17.77% for the year.  The S&P GSCI index, which measures commodities returns, gained 27.37% in the second quarter, recovering some of the 42.34% 1st quarter loss.  The index now posts a 25.39% loss for the year.

In the bond markets, rates continue to drag on at historic lows.  Coupon rates on 10-year Treasury bonds stand at an astonishing 0.68%, while 3-month, 6-month and 12-month bonds are still sporting coupon rates of 0%.  Five-year municipal bonds are yielding, on average, 0.46% a year, while 30-year munis are yielding 1.70% on average.

The market declined precipitously in March when people realized how much potential economic damage the COVID-19 virus, social distancing and the closing of many businesses could inflict on the U.S. economy.  Then the market experienced one of the best quarters on record amid widespread optimism that some are calling euphoria. 

Does that mean that the recent market gains represent a bubble?  The evidence suggests that it does; the real question is how out-of-line stock prices are from reasonable norms.  When you read about hairdressers day trading on Reddit, you know that at least some stocks are being bid up without too much concern about underlying valuations.  But when you look at the accompanying chart showing Price/Earnings ratios going back to 1880, you see that the market today is still priced below previous peaks.

Does any of this mean that a severe market downturn is coming, or that stocks still have room to appreciate?  That is a far more difficult question, for several reasons.  First, does anybody know how well companies are managing to keep up their operations when their workers are doing their tasks at their kitchen tables?  In other words, do we really know how much productivity and economic value is being lost during the pandemic?  This is uncharted territory for businesses and companies alike, but you could make the case that public companies (we’re not talking about bars and restaurants) are just marginally less valuable now than they were at the start of the year, that the damage will be minimal and life will go on in the corporate world when everybody finally gets back in the office.. It’s also possible that they’ve suffered huge damage to their bottom lines and viability and current prices are unsustainable.  You can have your opinions, but nobody really knows.

The other factor is the Federal Reserve Board, which appears to view itself as a fiscal backstop not only for the economy, but also for the markets.  Try to imagine a hypothetical investor who has unlimited money in the bank, who decides that stocks are not going to go down and companies will have money in the bank even if they don’t earn it through operations.  Would that investor ultimately have her way with stock prices?  You have just imagined the reality that is the Fed.  What we don’t know is how long and hard the Fed will fight to prevent a severe market downturn before, say, the November elections.

What are the facts on the ground?  June hiring data showed a sharp reversal from May’s 2.7 million job losses.  The ADP National Employment Report showed that more than 3.3 million workers were hired in the private sector in June.  In addition, the most recent manufacturing indices were stronger than expected.  But a total of 17 U.S. states have now paused their phased reopening programs due to the coronavirus, as the number of new daily cases rose 12.5%.  Some hospitals in Texas, Florida, Arizona and California are reportedly reaching capacity.  Then again, some news outlets report optimism that Pfizer–a component of the Dow Jones Industrial Averages and the S&P 500–had reported encouraging trial results of an experimental coronavirus vaccine, even though it’s unlikely that a vaccine will be available this year.

The conclusion of these analyses is always and forever the same: we honestly don’t know where the markets are going next, and we know with some certainty that trying to predict the market has, in the past, been a fool’s errand.  The most prudent strategy seems to be to play defense without abandoning the potential upside of equities until we know how the pandemic and its economic consequences play out.  That strategy would have underperformed in the past three months, and would have outperformed in the previous three. 

Coronavirus Aid, Relief, and Economic Security (CARES) Act — Summary


$1,200 for individuals; $2,400 for married couples + $500 per child under 17

Phase-out based on income (AGI) on 2019 tax return; if 2019 tax return has not been filed, based on AGI on 2018 tax return

  • $150,000 for married filing jointly (phase-out to $0 at $198,000)
  • $75,000 for individuals (phase-out to $0 at $99,000)
  • To be paid “as soon as possible,” but not likely before May
  • Social Security recipients to where they get SS checks
  • Direct deposit to wherever taxpayer received 2018/2019 refund
  • Otherwise sent to last known address on file

If underpayment of rebate based on 2020 income/tax return, additional rebate paid next year. If overpayment, no adjustment on “excess” payment.


  • Allows withdrawals from IRA’s or employer retirement plans up to $100,000 in 2020 if experiencing adverse financial consequences of COVID-19
  • Exempt from 10% early withdrawal penalty
  • Not subject to mandatory tax withholding
  • Eligible to be repaid over 3 years
  • Withdrawals are taxable; income can be spread over 3 years

Loans from employer-sponsored retirement plans expanded

  • Maximum loan increased from $50,000 to $100,000
  • Repayments delayed for up to one year

Mandatory RMD’s suspended for 2020

  • Applies to IRA, 401(k), 403(b), Inherited IRA
  • RMD’s may be able to be “returned” : If RMD already taken within 60 days, RMD can be “returned”; If RMD taken beyond 60 days, RMD can be “returned” if individual can show negative impact from COVID-19; “Return” option not available for beneficiaries of Inherited IRA’s who have already taken their RMD in 2020


Eligibility extended beyond W-2 employees to self-employed and contractors and people who have been furloughed

Elimination of 1-week waiting period

Regular” state unemployment benefit increased by $600/week for up to 4 months; paid by Federal government ($425 in DC pending)

Extension of benefits for additional 13 weeks


No payments required until September 30, 2020; no interest during the interim
Must be proactive to stop payments; not automatic
Employers can exclude student loan repayments from compensation


Definition of medical expenses expanded for HSA’s and FSA’s —

  • Includes over-the-counter medication
  • Includes menstrual care products

Medicare beneficiaries eligible for COVID-19 vaccine (when available) at no cost

Telehealth services may be temporarily covered by an HSA-eligible HDHP before a participant has met their deductible


There is a new “above-the-line” deduction for up to $300 of qualified charitable deductions (for taxpayers who do not itemize)


There are a variety of provisions in the CARES Act pertaining to small business, but this summary focuses on those provisions that will have a direct impact on individuals.

Earned Income Confusion

If you were voting for the most misunderstood part of the U.S. tax code, a strong candidate would be the Earned Income Tax Credit. The EITC (as professionals call it) represents a refundable federal income tax credit for low- to moderate-income workers.

Since it was installed in the tax code way back in 1975, it has helped offset the burden of Social Security taxes on people for whom the payroll taxes are most (or all) of their tax bite, and it also provides an incentive to work. Taxpayers who are eligible to claim the EITC may be entitled to a refund from the government even if they would otherwise owe no federal taxes.

Sounds pretty straightforward, right?  But there’s a swirl of misinformation around the EITC. You might have heard that the EITC is a welfare system for people who don’t work, but in fact only people with earned income are eligible for the credit—and passive income like interest and dividends doesn’t count.

Have you heard that only families with children qualify?  Not true. The amount of your tax credit is dependent on your income and the number of your “qualifying” children. Natural or adopted children under age 19, or under age 24 and a full-time student, qualify.

Nor, as some have alleged, can undocumented aliens qualify for the credit. You must be a U.S. citizen with a valid Social Security number or a resident alien for the entire year to claim the EITC.

It’s not always easy to know whether any particular person qualifies for the credit. If you have more than $3,500 of investment income in the tax year, you don’t qualify. You don’t qualify if your taxable income is over $55,952, or if you are reporting foreign earned income. Special rules apply to members of the military, members of the clergy, anyone receiving disability benefits and people impacted by disasters.  You don’t qualify unless you file a tax return, even if you don’t otherwise owe federal taxes. 

But many do qualify, and the EITC can be a welcome relief for people who are just barely making it financially. Last year, 25 million taxpayers received over $61 billion in tax credits under the EITC program, for an average of $2,504 in tax relief. The tax credit may be misunderstood, but it also seems to somehow be working.

Staying on Track: The Five Technical Principles of Financial Success

When it comes to your financial future, there are things you cannot control such as the stock market, the economy, or major world events. To increase your odds of financial success, I believe it is more important to focus on the things you can control. My Five-by-Five formula for reaching your financial goals includes five behavioral and five technical principles you can control. Today we’ll look at the five technical principles.

Have the Proper Asset Allocation
Asset allocation pertains to how your portfolio is divided among asset classes, i.e. equities (stocks) and interest earning (cash and bonds). I believe having an appropriate asset allocation can help people control their emotions during the ups and downs of the markets. For example, assume someone has 80% of their portfolio invested in equities but is unable to sleep at night, constantly worries about their investments, and then sells when the market goes down 20%.

This person has likely exceeded their risk tolerance. By selling every time the market goes down 20%, this person is sabotaging their financial plan. Having plenty of cash available to see you through downturns in the markets and for emergencies is also key to long-term success.

Be Properly Diversified Within Asset Classes
Within each of the asset classes, it is important to diversify among different types of investments. For example, I believe the equity portion of the portfolio should be divided among US-based small capitalization, mid capitalization, and large capitalization stocks, as well as international stocks from developed countries and international stocks from emerging market countries. I believe the interest-earning portion of the portfolio should be divided among cash (and cash equivalents), treasury bonds, and corporate bonds.

At any one time, nobody knows which investments are going to do well or struggle economically. Instead of guessing which type will do well, I believe it is better to diversify across many different types of investments. This spreads the risk around. At different times, different investments in the diversified portfolio will be doing better or worse than other investments.

Rebalance Periodically
Over time, a portfolio will drift from its original asset allocation. When this happens,  adjustments need to be made to get it back in alignment. For example, assume an investor starts out with an asset allocation of 60% equities and 40% interest-earning assets. Also, assume that the equity markets do well over time and this investor’s asset allocation drifts to 80% equities and 20% interest-earning because stock prices increased in value while bonds went down in value.

To get back to the original asset  allocation, some equities could be sold and the proceeds added to the interest-earning part of the portfolio. Why is it important to rebalance? Asset allocation drift changes the risk and as a result, the portfolio may no longer align with the investor’s risk tolerance or risk capacity.

Be Tax Aware and Tax Efficient
When I meet with prospective clients the first time, I ask them to bring their last three years’ tax returns to the meeting. I do this for several reasons. Not only do I learn more about them both personally and financially, but sometimes I find an opportunity to help them correct  an error in their tax return that will save them money.

Often, when I meet a new prospect I learn that they experienced an unexpected tax surprise in a recent year and paid a large tax bill to the IRS. This happens when  someone is not aware of their tax situation until it is time to file a return. I believe it is important to proactively manage the tax bill and avoid unexpected surprises.

I tell my clients that almost every financial decision they make has an impact on their taxes. When drawing money out of an IRA, selling investments in a brokerage account, buying or selling a house or other asset, it is important to know the effect on taxes. Proper planning can help identify opportunities to legally reduce or eliminate taxes.

Keep Expenses Low
In general, I believe in investing in low-cost passive index mutual funds and ETFs. Historical data shows that over long periods of time, actively managed funds do not consistently outperform the benchmarks they are trying to beat. Index mutual funds and ETFs generally cost less than actively managed funds.

As an example of the cost savings that can be achieved, if $500,000 were invested in a portfolio of actively managed mutual funds with an average expense ratio of 1%, the annual expenses on the portfolio would be $5,000. If $500,000 were invested in index mutual funds with an average annual expenses would only be $500. Over time, these savings add up.

Source: Steven Clark, CPA, EA Coconut Creek, FL

Pay Down Debt or Save for Retirement?

You can use a variety of strategies to pay off debt, many of which can cut not only the amount of time it will take to pay off the debt but also the total interest paid. But like many people, you may be torn between paying off debt and saving for retirement. If you’re not sure you can afford to tackle both at the same time, here are some of the factors you should consider.

Rate of Investment Return versus Interest Rate on Debt
Probably the most common way to decide whether to pay off debt or to make investments is to consider whether you could earn a higher after-tax rate of return by investing than the after-tax interest rate you pay on the debt. For example, say you have a credit card with a $10,000 balance on which you pay nondeductible interest of 18%. By getting rid of those interest payments, you’re effectively getting an 18% return. That means your money would generally need to earn an after-tax return greater than 18% to make investing the smarter choice. That’s a pretty tough challenge even for professional investors.

Bear in mind that investment returns are anything but guaranteed. In general, the higher the rate of return, the greater the risk. By contrast, the return that comes from eliminating high-interest-rate debt is a sure thing.

An Employer’s Match May Change the Equation
If your employer matches a portion of your workplace retirement account contributions, that can make the debt versus saving decision more difficult. Let’s say your company matches 50% of your contributions up to 6% of your salary. That means that you’re earning a 50% return on that portion of your retirement account contributions.

If surpassing an 18% return from paying off debt is a challenge, getting a 50% return on your money simply through investing is even tougher. Plus, you know in advance what your return from the match will be; very few investments can offer the same degree of certainty. That’s why many financial experts argue that saving at least enough to get any employer match for your contributions may make more sense than focusing on debt.Don’t forget the tax benefits of contributions to a workplace savings plan. By contributing pretax dollars to your plan account, you’re deferring anywhere from 10% to 39.6% in taxes, depending on your federal tax rate.

Your Choice Doesn’t Have to Be All or Nothing
The decision about whether to save for retirement or pay off debt can depend on the type of debt you have. For example, if you itemize deductions, the interest you pay on a mortgage is generally deductible on your federal tax return. Let’s say you’re paying 6% on your mortgage,18% on your credit card debt, and your employer matches 50% of your retirement account contributions. You might consider directing some of your resources to paying off the credit card debt and some toward your retirement account to get the full company match while continuing to pay the tax-deductible mortgage interest.

Time is your best ally when saving for retirement. If you wait to start saving until your debts are completely paid off, you might never start saving. It might also be easier to address both goals if you can cut your interest payments by refinancing that debt. For example, you might be able to consolidate multiple credit card payments by rolling them over to a new credit card or a debt consolidation loan with a lower interest rate.
Bear in mind that even if you decide to focus on retirement savings, you should make sure that you’re able to make at least the monthly minimum payments owed on your debt. Failure to make those minimum payments can result in penalties and increased interest rates.

Other considerations
When deciding whether to pay down debt or to save for retirement, make sure you consider the following factors:

  • Having retirement plan contributions automatically deducted from your paycheck eliminates the temptation to spend that money on things that might make your debt dilemma even worse.
  • Remember that if your workplace savings plan allows loans, contributing to the plan not only means you’re helping to provide for a more secure retirement but you’re also building savings that could potentially be used as a last resort in an emergency.
  • If you focus on retirement savings rather than paying down debt, make sure you’re invested so that your return has a chance of exceeding the interest you owe on that debt. While your investments should be appropriate for your risk tolerance, if you invest too conservatively, the rate of return may not be high enough to offset the interest rate you’ll continue to pay.

Source: Mike Skolnick, CPA FPS, San Diego, CA

The Three Ghosts of Gift Tax

Gifts are not taxable income. However, they can come back to haunt you! Be aware of the three ghosts of gift tax.

The first ghost will come if you are applying for a mortgage and the bank is trying to determine where you’re getting the money for your down payment. They want to make sure you’re not taking out a side loan (and are hence a worse risk to them because of your greater debt burden). If you are going to use gift money to buy a house, they will want a letter from the donor stating it’s a gift and not a loan.

The second ghost will come wanting evidence of a gift to prove that it is not taxable income. Once I had a self-employed person get audited by the IRS. The first thing the IRS does with a self-employed person’s audit is add up all the deposits into their bank accounts to see if it’s more than the income they claimed. The IRS came back and said his deposits into his bank account were $8,000 more than he showed on Schedule C. In fact, they said, he’d left off all his August income. He claimed he didn’t even work that August! Curious, I asked why he hadn’t worked. He said it was because he’d gotten married. Aha! Those deposits were wedding gifts, not subject to income taxes! Happily, we could prove he’d really been married then, and that a large deposit went to pay for the wedding—it really was from his parents.

The third gift tax ghost comes for the paperwork, which can be a bit complex. The first thing to know is that you don’t have to do anything if the gift was less than some “de minimis” annual exclusion. De minimis literally means “so little we can disregard it.” The annual exclusion was $10,000 for many, many years, and started to climb with inflation a few years back. For 2018 it’s $15,000 per recipient. So, you can give $15,000 to your daughter and $15,000 to your son and $15,000 to your son-in-law and $15,000 to your daughter-in-law… and if you’re married your spouse can do the same thing. That’s $15,000 all-in, including Christmas presents (there are some exceptions surrounding payments made directly to a hospital or college).

If you get a gift of whatever amount, it’s all cool. Make a note in your checkbook, maybe copy the check for your tax files, and send a thank you note (I didn’t have to tell you that, I’m sure). You can stop reading here. Fa la la la, enjoy your day!

The problem is if you give a gift over the annual exclusion rate. Now you have wandered into the territory of estate taxes—the tax you pay when you transfer money from one generation to another.

Here’s how it works.

Imagine you’ve got a net worth of $12,000,000 and you’re feeling a bit peaked. Imagine also that you know that the estate tax exemption happens to be $11,180,000 right now. You gather your two beloved children to your bedside and say “here, each of you, have $1,000,000 each.” You bring your net worth down to $10,000,000 and then die the next day. Did you cheat the tax man? No! Because gifts over the annual exclusion amount get added back to your estate transfer] tax return.

In fact, all the gifts you made in your entire lifetime above the “de minimis” amount get added back to your estate tax return. Depending on the estate tax exclusion level in the year you die, the gifts you gave may or may not cause you to have to pay any actual tax, but all the gifts you ever made eat away at a lifetime exclusion that isn’t actually knowable until the day you die; estate tax exclusions shift around a lot depending on who’s in control of Congress.

How do gifts you made in 1997 get added to your estate transfer return when you die in 2047? Paperwork! Really dreadful paper-work that literally follows you to the grave. When you give a gift over [whatever the annual exclusion is that year], you must file a gift tax return and tuck it into a folder called “Estate of [Your Own Name]”. It’s not a hard return to do, but you’ll probably pay an accountant a couple of hundred dollars to do it, and you’ll be stuck with a folder in your filing cabinet that your heirs/accountants/lawyers should know about when you die.

There you have it: give gifts of above $15,000 a year per per-son per recipient and you’re saddled with serious paperwork requirements. It’s not (usually) a tax, but it’s taxing nonetheless. If the ghosts of gift tax come for you this year, you can be ready for them.

Source: Wendy Marsden, CFP®, CPA, MS, Greenfield, MA

Minimize Taxes to Build Wealth

Because we pay attention to all aspects of your financial life, we know when you can realize tax savings by:

  • Restructuring your investment portfolio,
  • Shifting income to dependents in lower tax brackets,
  • Claiming appropriate office-in-home deductions,
  • Maximizing retirement plan contributions,
  • Identifying all the deductions that apply to your small business,
  • Using charitable gifting strategies more effectively,
  • Amending prior-year tax returns,
  • Or implementing other tax-saving strategies.

Objective Investment Advice to Grow, Protect, and Manage Your Wealth

Growing, protecting, and managing your wealth requires answers to many questions, including:

  • Do I buy individual stocks, mutual funds, ETFs, Treasuries, commodities, gold, or just leave my money in my savings account?
  • How much am I really paying for my investments?
  • What are the tax implications of the investments I select?
  • Which investments should I hold in my retirement accounts instead of my brokerage accounts?
  • Are my investments properly diversified?
  • Are my investment decisions sometimes driven more by emotion than objective analysis?

Our professional investment advice is fully integrated with your comprehensive financial plan, giving you the security and confidence that you have the best investment strategy for meeting your goals.

Functional Asset Allocation for Growing Your Net Worth

Most financial planners and investment advisors focus on your investment portfolio and its performance against various indexes.  While your investment portfolio is important, it’s only part of the picture.  Your overall net worth is a much better measure of your financial well being and your ability to achieve your goals.

Functional Asset Allocation is a holistic approach to net worth management and growth.  Its most basic premise is that there are three major categories of assets – interest-earning, real estate, and equities – and that each category has a fundamental function or purpose.

The purpose of the interest-earning category, which includes cash and bonds, is capital preservation.  These investments protect against deflation and ensure that you will have a reliable cash flow while keeping this part of your portfolio safe.

The real estate category includes your personal residence, real estate that produces income (rental property, for example), and nonproductive real estate (including vacant land and second homes).  The purpose of real estate is to protect against inflation through the opportunity to leverage your investment by mortgaging the property.  It also fulfills the function of personal use and enjoyment.

Equities produce profits during times of prosperity.  They are the growth engine of your net worth.

Once you understand the function of each asset category you see how questions like “Should I invest in stocks or bonds now?” are fundamentally flawed.  Under Functional Asset Allocation, the three asset categories don’t compete against each other on performance or yield.  The better question is “Do I have the right investments in each asset category, and am I properly balanced across all three categories so that I can achieve my goals and worry less about my finances?”

We can help you answer that question with a resounding “Yes.”

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 you 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. 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.

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 a very important factor to consider.

Risk 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.

Factors affecting 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 future.

Risk Capacity Examples

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.

Now consider 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.

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 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:

  • 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 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