Understanding Risk Capacity vs Risk Tolerance
When discussing risk in investments, you will usually hear a lot about risk tolerance. However, I'd say that understanding your risk capacity is potentially even more important than your risk tolerance.
What is Risk Capacity and how does it differ from Risk Tolerance?
Risk tolerance indicates how you feel about losses: whether they make you anxious and would rather not--quite literally-- take the risk of losing money, or whether you like to take chances and feel quite comfortable risking your investments. Risk capacity indicates the extent of which losses will derail your retirement plan and if you even have the capacity to withstand those losses and still be in okay shape. This distinction is essential because while I may be able to emotionally tolerate loss well, my financial capacity to sustain those losses could be prove to be unstable and problematic.
Your risk tolerance is traditionally assigned by using generic terms to define the group you belong in: conservative, moderate, or aggressive. However, these classifications do not give you any true guidance on how you should invest in order to reach your goals. They are general, minimally informative categories made without personalization in mind and are not intuitive in associating your ability to tolerate loss with your capacity to handle it.
I believe very strongly in starting with your end goal in mind. Why do we even give up current enjoyment of our money in the first place? It's because we are trying to build lasting wealth and that requires that we begin with a strategy. Unfortunately, many people just save without a clear strategy, or their only strategy is to save as much as possible. This certainly has its merits, and is definitely better than not saving at all, but what's more important than just saving as much as possible is making sure you have the maximum income possible. Because, in retirement, it's not so much about how much money you have but how much money you are able to spend.
So, how do you begin understanding what your risk capacity is? You can start by creating a retirement map which will show, on a probability basis, how likely you are to run out of money. This map is based on the Monte Carlo analysis theory.
Your capacity is calculated by finding the amount of losses that would negatively affect your retirement goals, and keeping your capacity below that amount. Meaning that if losing $50,000 prevented you from the income you needed in retirement, you would be considered to have a risk capacity of less than $50,000.
It's important to take a look at your portfolio and determine the dollar amount of actual losses that would derail your goal. A retirement map powered by the Monte Carlo analysis can provide an understanding of your probability of success while also taking losses into consideration by subtracting increments of $25,000 or $50,000.
The graphic below shows a 95% probability of success in retirement, based on an investor's current investments, and assuming that the investments will continue at the same rate and amount. The graph indicates that they will need $1,199,800 by retirement, and that they will accumulate $1,355,763 by retirement if they continue investing as they are now. That means that they are over-funded by approximately $150,000, which becomes their risk capacity (because they could afford a loss of $150,000 and still stay on target for a financially successful retirement). Losses over $150,000 would put their plan at risk, so that is the full capacity of their risk.
In conclusion, we cannot deny that both risk capacity and risk tolerance are critical to achieving financial success, and we must remember the context of how the two interact with one another to inform how your retirement funds should be invested. By using your risk tolerance as a guide, you can positively steer your investments -- but only within the confines of your risk capacity.