Risk Capacity & Risk Tolerance: The Foundation of Investment Planning
By: Chelsea A. Benoit, CFP® Associate Advisor
One can think of creating an investment plan as finding the best way to assemble the pieces of a financial puzzle. After deciding on the goal(s) of your investment plan, determining the appropriate level of risk to assume to accomplish these goals is essential. This question requires considering both your risk tolerance and risk capacity or, broadly speaking, your risk profile.
Risk tolerance pertains to your comfort level given a certain degree of risk while risk capacity considers whether you can reasonably afford to undertake a given amount of risk given your goals and financial situation.
Risk tolerance is an emotional aspect of portfolio construction and is subjective by nature. In contrast, risk capacity objectively looks at your financial picture and considers your goals along with current and future financial resources to support meeting those goals. This includes how, when and from which sources it is anticipated this may occur. For example, the sooner you expect to start withdrawing from your portfolio or the more dependent you are on your portfolio to provide income, the lower your capacity for risk. Conversely, the more robust income sources you have or the longer you can defer drawing down on your portfolio, the higher your risk capacity. Both risk tolerance and risk capacity should be evaluated together to determine the most appropriate asset allocation for your portfolio. Taken together, this risk profile is intended to align your comfort level of risk with an investment portfolio designed to aid in the accomplishment of your objectives. A risk profile is planned for a long-term investment horizon and typically changes only due to a significant life event over the life of your portfolio.
Another important factor to consider is the sensibility of taking on more risk than is necessary. Let us look at a hypothetical example. A risk-tolerant couple is retiring in two years with low cash needs and ample income sources outside of their investment portfolio to fund their retirement. They have no plans to leave an inheritance and would like to deplete most of their portfolio during retirement. The couple’s risk tolerance suggests that they could accept the greater volatility of a portfolio more heavily weighted in stocks. Their risk capacity is high because a significant decrease in the portfolio’s value would not have a major impact on their financial well-being since they have other sources of income and do not need to leave funds to their heirs. Although the couple’s risk tolerance and risk capacity align well in this situation, it may not be prudent to have an aggressive asset allocation for this couple. A portfolio with a more balanced allocation between fixed income and equity investments could achieve the couple’s goals without exposing them to unnecessary risk.
At Goodman Financial, evaluating our client’s risk profile and determining an optimal portfolio allocation is a collaborative effort between the advisor and client. Prior to establishing an investment portfolio, we collect data, utilize our Risk Tolerance Questionnaire and pair those responses with the information we gathered from our discussions with clients to determine an appropriate asset allocation. Then, we discuss our asset allocation recommendation with clients to ensure their comfort level and adjust, if necessary. We not only want to help clients achieve their goals, but we want to do so in a way that will provide peace of mind.