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