Risk Tolerance and Risk Capacity

Finding an appropriate investment strategy is not a simple task, especially if the world of investments is somewhat foreign to an investor. Everybody is looking for that investment nirvana which includes steady, high returns with little to no disruptions. Unfortunately, that is not the way the world works and most people are aware of a trade-off between risk and return. As was discussed in a previous blog, Risk to the Upside , risk cuts both ways. There is the risk that your investments decline in value which is where most people focus. And then there is the risk that an investment strategy is too conservative, thus robbing an investor of growth potential and letting inflation do its insidious work. An understanding of this concept then begets the question of just how much risk is one comfortable with. Discussing the interplay between tolerance and capacity to take risk can help the decision-making process.

From a personal standpoint, I have always had the desire to seek activities that get my adrenaline pumping. I’m a fiend for the biggest and scariest roller coasters and in my younger years, I made the decision to jump out of a perfectly good airplane. For those who have never done it, it is an experience unlike any other. Nowadays, I wouldn’t dream of doing it for a simple reason: I have a family who depends on me. Being young and single afforded me opportunities to take those risks and skydiving marked the confluence of a high tolerance and capacity to take risk. My tolerance is still there, but my capacity is greatly diminished.

With that in mind, let’s shift our focus to investments. A commonly heard heuristic for choosing an allocation for your retirement accounts is that your age roughly equals the fixed income portion of your portfolio with the remainder to be held in stocks. As one ages, the more conservative a strategy should become. In fact, this is the driving force behind the glide path that most Target Date funds found in 401(k) plans adhere to. An investor’s age and years until retirement are two of the inputs in the capacity to take risk, but this is where that heuristic falls short. Availability of other forms of income (such as a pension or business interests) during those retirement years can add to one’s capacity for risk. If your goal is a large inheritance for your heirs and you live an appropriately frugal lifestyle, you are awarded more capacity points. Underlying all these factors is time. The longer you can stretch the liquidation phase, the more capacity for risk exists.

Capacity is fairly easy to quantify especially if you are working with a Certified Financial Planner. Tolerance is much more nebulous and personal. I have dealt with clients in their 20’s and 30’s whose investment experience has been scarred by some combination of the Global Financial Crisis and the COVID-19 pandemic. Much like someone experiencing a close call during an X-Games activity, their desire to take on risk has shifted down. I have also dealt with clients well past the commencement of their Social Security benefits willing to dial their risk up to 11. As I have said before, the best investment strategy is one you can stick with through the good times and especially the bad times. If your portfolio is making you lose sleep at night, chances are you are invested too aggressively.

A regular review of a financial plan boosts the awareness of both variables in this equation and that is why having one is essential to your financial health. Not only can you monitor the qualitative and quantitative factors that determine the risk level in your investments, but a financial plan allows you to view your investments as a part of a bigger picture. A siloed view can cause you to focus on the wrong things at the wrong time which can lead to bad decisions. As always, our team is here to help with any questions you may have.