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Risk Tolerance Vs Risk Capacity

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If you’ve ever worked for an employer who offered a workplace retirement plan, like a 401(k), you have probably completed a risk tolerance questionnaire at some point in your life. While most working adults are maybe at least somewhat familiar with a risk tolerance questionnaire very few folks have every been introduced to the concept of risk capacity. Risk capacity is risk tolerance’s less famous sibling.

Although they may sound similar, risk tolerance and risk capacity are very different from one another. It is important to understand both your risk tolerance, and your risk capacity before making any investment decisions. In fact, I might argue that risk capacity is more important than your risk tolerance.

To clearly understand the difference between risk tolerance and risk capacity we will start by defining each on their own. Then from there, we can explore how they can differ from one another, and how you might be able to determine what a good balance of risk tolerance and risk capacity is for yourself.

Risk Tolerance

Let’s begin with risk tolerance, since you may be somewhat familiar with that one already. Risk tolerance is a qualitative assessment of your appetite for risk. It’s an emotional reaction to the potential for investment losses. You can think of risk tolerance as a feeling. It’s you’re feeling about investment risk, specifically how you feel about investment losses.

Risk tolerance questionnaires are often used to make a judgment of your risk tolerance based on subjective questions. After completing a risk tolerance questionnaire, you may be shoehorned into one of several categories of investment risk based on your answers. For example, you may be identified as a conservative, moderate, or aggressive investor or somewhere in between these subjective points. The purpose of a risk tolerance questionnaire is to help determine the right blend of lower-risk lower assumed return investments, and higher-risk higher assumed return investments within your portfolio.

It is possible that two nearly identical people with nearly identical financial circumstances could have wildly different tolerances for investment risk? The answer is a resounding yes!

Human Emotion and Risk

Because risk tolerance is a qualitative measure rather than a quantitative measure it is extremely subjective and grounded in human emotion. Human emotions are unpredictable, and rarely lead to rational decision making. Human emotions are influenced by past experiences. Past experiences create biases.

Every person on the planet experiences life in a slightly different way, and each person interprets those experiences through his or her own world view. That is how two seemingly similar individuals with nearly identical financial circumstances could have wildly differing risk tolerances. Therefore, risk tolerance on its own may not be an appropriate benchmark for making crucial investment related decisions.

Risk tolerance also seems to be fluid. Someone’s risk tolerance may change over time. Often, someone’s risk tolerance will increase during a period of economic boom with corresponding positive market returns. Think about it. You are feeling confident when things are going well, and your risk tolerance may shift toward taking more risk.

On the other hand, someone’s risk tolerance may decrease during a period of economic recession and corresponding market decline. When negative feelings of scarcity and loss take hold its foreseeable that your appetite for risk would shift toward being more conservative, to conserve what you have remaining.

Never forget that risk tolerance is based primarily on human emotion, and human emotions tend to shift as circumstances change.

Risk Capacity

So, what is a risk capacity? Risk capacity is a quantitative measure. It is an assessment of your financial plan’s ability to absorb losses without causing alarm or threatening to impact your future desired outcome. Said another way, risk capacity is a data driven measure of how much loss your financial plan can take before it breaks.

Risk capacity is data driven. It is a logical measure of risk rather than an emotional one. That is what makes it so different from risk tolerance. Risk capacity is based on many factors, but ultimately what it boils down to is the answer to this question. How much loss can your financial plan sustain and for how long while your investments recover while still permitting you to maintain a desired consistent lifestyle?

Someone with a high-risk capacity may have sufficient cash flows to cover the current lifestyle spending. For example, a person in her prime earning years with relative job security whose current income far outpaces the cash outflows necessary to maintain her desired lifestyle may have a higher capacity for risk. This is because negative market fluctuations would have little impact on her ability to maintain her lifestyle. In fact, she may be in a position to take advantage of the opportunity presented when negative market returns occur by directing excess cash flows to purchase undervalued assets. Her risk capacity may be very high regardless of her risk tolerance, or how she feels about risk.

On the other hand, a person who has recently retired may be in a very different situation. He may have inadequate cash inflows (once his final paycheck is deposited) to cover the majority of cash outflows necessary to maintain his desired lifestyle. He may be heavily reliant on his retirement savings. The necessary consumption of invested retirement assets to supplement income may greatly reduce his risk capacity for the foreseeable future. Experiencing negative market returns would likely impact his ability to maintain his throughout retirement, and he’d be forced to adjust his spending habits in order to take pressure off his investable assets until they can recover. We might say that his capacity for risk is far less than the woman in the previous example.

Balancing Risk Tolerance and Risk Capacity

Is it possible that one person could have a high-risk tolerance and low risk capacity? Is it possible that another person might have a low risk tolerance and a high-risk capacity? The answer to both questions is, “of course.”

Henry Races to The Finish

Risk tolerance, being emotionally driven, may result in someone feeling like he can take on a lot of risk when in fact his plan would suffer tremendously if he experienced significant investment losses.

Take Henry for example. Henry is 60, and five years away from transitioning from his working years to his post working years. He’s feeling like he needs to accumulate more retirement assets in the next 5 years, so he’s driven to take on more investment risk. He’s sprinting to the finish. All of his investments are tied up in retirement plans invested in marketable securities. Nearly all of his retirement resources are subject to market risk.

Besides Social Security he has no other sources of lifetime income to replace his paycheck once he transitions into retirement. His Social Security benefits will cover about 30% of his current lifestyle spending. The remaining 70% of his lifestyle spending will have to come from his retirement assets. He’ll be heavily reliant on his investments, and the distribution of those investments to allow him to maintain his lifestyle adjusted for inflation and taxes for the rest of his life.

Henry’s feeling pretty good about the market. His investment returns over the last decade have been extraordinary. Emotionally he feels pretty positive. His positive outlook has him feeling optimistic about future market returns resulting in a relatively high-risk tolerance for someone in his situation.

However, does he have a high-risk capacity? Henry’s capacity for risk may not be as great as what his risk tolerance may lead us to believe. There really isn’t enough information about his circumstances to have a definitive answer. However, we could conclude that a severe market downturn that last several years or longer from the peak to trough and back to a full recovery could significantly impact Henry. His ability to maintain his current lifestyle without the risk of running out of retirement resources throughout his retirement years may be in jeopardy unless he makes some unwanted reductions to his lifestyle.

Susan Is Set for Life

On the other hand, it is possible for someone with a low risk tolerance, feeling like she cannot take risk with her retirement asset, to have a higher risk capacity and be virtually unaffected by a steep market decline.

Susan is a 78-year-old widow. Between her deceased husband’s pension and her survivor benefit from Social Security she has enough monthly cash flow to cover 120% of her current lifestyle spending. In other words, she has more money coming into her household than what she spends each month. Susan deposits the excess cash flow into a savings account each month, and occasionally buys a certificate of deposit. In fact, over 80% of her retirement assets are currently being held in cash equivalents like savings accounts and CDs. Only 20% of her money is currently in Stock market investments.

As a general rule of thumb, a financial industry professional might recommend that nearly 80% of Susan’s retirement assets be placed in low-risk low-return savings of investments. For example, fixed income investments like bonds, fixed interest deferred annuities, or cash savings like CDs or savings accounts may be appropriate because of her age. In fact, there’s a well know rule of thumb in the financial industry called the “Rule of 100.” It states that a person’s assets subject to stock market risk vs assets not subject to market risk can be determined by subtracting their age from 100. In this case, Susan should have only 22% of her assets (100 – 78 = 22) subject to stock market risk based on the “Rule of 100.”

However, from a risk capacity standpoint does this really make sense?

Considering Susan’s monthly cash flow is 120% of what she currently requires to maintain her lifestyle does she need to shelter 78% of her investments from stock market risk? Does she need to forgo potentially far greater investments returns over time in order to protect her retirement assets from losses resulting from a temporary downturn in the stock market? Not necessarily!

There’s not enough information in this story to determine what specifically would be appropriate for Susan. Many factors determine risk capacity, including the intended purpose for her retirement assets, and the timeline for which they will be needed. However, I think it’s safe to conclude that her capacity for risk is much greater than what Henry’s was even if her risk tolerance is less.

Where Do you Begin to Understand Your Own Risk Capacity?

To determine your own risk capacity consider drafting a well written retirement income plan. A well written retirement income plan will balance quality of life measures like you family values, goals, and vision for the future against the quantitative resources you’ll have to work with throughout retirement.

Organize all of your retirement resources, both income sources like social security and Pension if you’re fortunate enough to have one, and retirement assets like IRAs, 401(k)s, and other IOUs the IRS as well as personal savings and investments.

Then develop a detailed spending plan reflecting your current and future desired lifestyle. Don’t forget to appropriately adjust specific items on your spending plan for inflation. Some expenses you may have now are not inflated and even go away at some point, like mortgage principal and interest. Other spending items may need to be planned for the remainder of your life like food, clothing, energy, and other consumer goods and service. Expenses such as healthcare may increase at a much more rapid pace and need to be adjusted at a higher rate of inflation.

Don’t forget taxes either! Taxes on distributions from pretax accounts can greatly reduce the spending power of your retirement resources, and even trigger unexpected taxation or surcharges on entitlement programs like Social Security and Medicare.

Once you’ve completely organized all of your retirement resources accounted for your desired retirement lifestyle spending adjusted for inflation and taxes you can stress test your written retirement plan for its ability to withstand certain levels of market losses.

You can evaluate the tradeoffs between the potential benefits of long-term market-based investments, and the impact of a potential and prolonged negative market downturn on your ability to maintain a desired standard of living.  

In the end you might find that your appropriate blend of asset allocation may be found somewhere between you risk tolerance and your risk capacity.

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