Capacity and Tolerance

Risk is an interesting concept. If you looked it up online you'd find millions of references to risk taking. There are quotes, books, and papers from famous artists, writers, past presidents, and yes, financial gurus. They all pretty much agree on one thing: risk taking is the stuff of life. And this is absolutely true in the world of investing.

Quite simply, without taking risk you'll never really get anywhere with your investments. Yes, it might feel good to avoid risk but eventually you'll wind up losing due to hidden risks that are insidious and extremely damaging. It's not a question of whether to take risk or avoid it, but how much risk to take.

Figuring out the answer to this question occupies a large amount of time for financial planners and their clients. But it's often glossed over by many in the industry.

Investment risk is complicated, so let's focus on two key concepts: risk capacity and risk tolerance.

Risk capacity is an analytical evaluation that is dependent on the details of an investor's financial plans. This is about how much risk you can afford to take instead of how much you want to take.

Let's look at a simplistic example. Say an investor who wants to protect her principal is looking to retire and needs to generate $30,000 each year from her $1.2 million investment portfolio.

This investor is lucky in that she could simply buy government bonds and spend the income they provide (currently about 2.5% per year). The only risk she would need to take in this scenario would be that of the U.S. Treasury going bankrupt during her lifetime, and most of us would agree that this is a low risk. Following this approach, the investor would be trading away growth potential for safety.

What's this investor's capacity for risk? If she only needed $30,000 per year, we could say that she could afford to take additional investment risk, and that she has a high risk capacity. We might even say that she should take more risk. Why? Because inflation would degrade her purchasing power over time and, depending on how long the investor thought she might live, her lifestyle would degrade as well. Investing a portion of her portfolio in stocks would be necessary to combat inflation.

Now, flip the scenario around. Assume the investor needs the same $30,000 from her portfolio, but instead of $1.2 million she has $200,000. You might think this means the investor should take on lots of risk to try and grow her portfolio as quickly as possible to cover the required 15% return. The irony here is that in this scenario the investor has a high need but a low capacity for risk and would need to plan very carefully to avoid running out of money too soon.

Risk tolerance is something most investors have heard of before. Brokerage firms often ask a handful of straightforward questions to gauge how investors feel about taking risk. They might ask why you're investing, what your history is with investing, and how long you plan on investing for. This is pretty simplistic and many firms stop at about this point.

But do those questions get to the core of an investor's tolerance for risk? Do they address risk capacity? No.

Go back to the prior examples. The first investor would likely be labeled "conservative" by a risk tolerance questionnaire. But is this investor aware of the risks she'd be taking by investing only in government bonds? Does she understand the importance of having at least a portion of her portfolio in stocks? She might not want to, but at least she should make an informed decision.

In the second example, the investor might be a real risk taker, and be labeled as "aggressive". She might even be willing to bet it all on black and hope for the best. Would this be prudent? Of course not. She could get lucky or might torpedo her financial future. Will she be educated about the fundamental dilemma she's facing?

In practice, determining an investor's risk capacity and risk tolerance is a hard thing to do right. It takes comprehensive planning to give the planner (and investor) a big-picture view of how much risk they can take, should take, and how to weigh this against how much risk the investor wants to take.

Comprehensive planning is part of my service offering, but I also leverage technology to help investors better understand how different levels of risk impact their plans.

Along these lines, I just bought a new and innovative technology package from a Sacramento-area company called Riskalyze. I was recently reminded about this by a client and decided to pull the trigger after meeting the company reps at a conference.

While not a standalone replacement for broader analysis, Riskalyze is a very useful tool for investors to get beyond the standard industry jargon of "conservative", "moderate", and "aggressive" and provides a more personal look at investment risk.

This is now available on my website. Feel free to check out the new page and determine your "risk score". We can discuss it together soon.

http://www.ridgeviewfp.com/resources/evaluating-risk.html

Have questions? Ask me. I can help.