As financial advisors, we are constantly having conversations with clients about the “R” word – risk. Managing risk is a critical aspect of achieving financial goals, constructing sustainable portfolios, and in general, living a more peaceful life, but the perceptions of risk can vary widely. Whether you’re a retiree enjoying the fruits of your labor or a business owner steering through the complexities of entrepreneurship, risk affects us all, and it’s crucial to find the balance between emotional resilience and financial stability.
I’m going to frame the distinction between two fundamental concepts: risk tolerance and risk capacity and explain why both need ongoing attention when planning and pursuing goals.
Risk Tolerance = Emotional Resilience
How comfortable are you with risk? Your emotional comfort level when facing market ups and downs is a big factor that plays into decision-making and financial planning. We call it risk tolerance but think of this as your psychological readiness to handle market fluctuations. For retirees, this may translate into how you react to seeing your nest egg fluctuate in value, while for business owners it could reflect your ability to withstand the uncertainties of market cycles.
As an industry, we have all sorts of tools to help clients and advisors identify their risk tolerance. A mentor of mine told me early in my career that the best portfolio for a client is the one that they can “stick with” in the good times and bad times. Admittedly, I probably didn’t fully grasp what he meant in that moment, but over the past two decades of working with clients, I’ve witnessed how emotions can spoil a client’s best-laid plans.
My mentor wasn’t suggesting never to make changes, but rather to be very conscious of how changing emotions can play a critical role in long-term outcomes. At times it might seem burdensome but asking yourself how you’re feeling about various risks helps bring clarity, comfort, and confidence to issues that seem completely out of your control.
Risk Capacity = Financial Stability
While risk tolerance focuses on psychological factors, risk capacity deals with the more “black and white” financial ability to take on risk. It represents the ability to purely absorb losses without jeopardizing your financial well-being. If you’re a retiree, this means doing a deep dive into income sources and savings vs. expenses in the pursuit of meeting life’s ongoing financial needs over several decades. If you’re a business owner, it means looking at your company’s cash flow, debt obligations, and growth aspirations for what is on the horizon in various economic cycles.
Often, financial professionals will use “stress test” simulations to encapsulate a client’s risk capacity. The attempt here is to determine if a desired outcome is feasible based on where things are positioned today, where they could potentially go (good and bad) in the future, and actions that could be taken. This is probably a good time to mention that a goal needs to be defined to make this exercise worthwhile – something that can be elusive for some as wealth increases over time. I love golf and one of my favorite characters is six-time major champion Lee Trevino who is famously quoted as saying, “Pressure is when you play for five dollars a hole with only two in your pocket.” This mentality is a perfect display of high-risk tolerance, but low-risk capacity. While I wouldn’t dare challenge Mr. Trevino on the golf course, one can see how unnerving that attitude could be when it comes to your retirement or business. By quantifying your risk capacity, you can better understand how much risk you can afford to take within the context of your broader financial plan.
When it comes to retirement planning, there are several things you will need to consider and evaluate to begin identifying your risk capacity. This list is not exhaustive, but below are some things to ask yourself to begin formulating where you stand with your ability to take on risk.
- How long will it be before you need funds?
- What will your guaranteed income sources be? (i.e. Social Security, Pension benefits, etc.) How much will these amount to?
- What are your current monthly and annual expenses? Will your desired lifestyle or expenses change in retirement?
- If you’re currently working, how much does your income fluctuate in any given year?
- What tax exposure do you have both now and in the future?
These are all good questions to be able to answer to start thinking about your risk capacity and how that pairs with your risk tolerance.
The Risk of Not Understanding Risk
Striking a balance of risk tolerance and risk capacity that works for you really is the pitting of the emotional vs. financial and the subjective vs. objective. In essence, it’s the capability to identify someone’s emotional readiness to tolerate investment volatility as well as their financial ability to withstand losses. It can be easy to confuse the two.
It’s not uncommon for a client to convince themselves that they are ready to take on a risk that they are not truly comfortable with to produce their desired outcome, only to find themselves in a dire position in the future because the amount of risk taken did not coincide with their capacity.
It’s also not uncommon to have opportunities missed where capacity is high, but the emotional readiness just isn’t there. While the former is less desirable than the latter, it does illustrate the importance of constantly assessing both in the context of pursuing financial goals.
Grasping the disparity between risk tolerance and risk capacity empowers you to make informed decisions aligned with your financial objectives. As retirees or business owners, navigating the complexities of risk management requires a balance between emotional comfort and financial prudence. Having conversations and creating an action plan with a team around you that understands this can help optimize risk-taking within the confines of your risk tolerance and capacity, paving the way for a secure and prosperous future.
Compliance Notes: Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.
