Risk Tolerance and Risk Capacity

Alright, we’re back from our honeymoon but since we’re still recovering from jet lag I’ve got one last guest post from my friend Jacob.  I’ve already gotten started on the first few posts for our honeymoon trip review and I think it’s going to be a great series.  I’ll likely start the series next Friday for those who are interested in finding out how we were able to fly business class on Turkish airlines and get to spend two hours in one of the most amazing airport lounges in the world 🙂  All for free..

Today I’d like to share a few words on risk that might influence your investment portfolio and your asset allocation.

A common measure of investment risk is the standard deviation of returns, or the ups and downs of an investment portfolio. However, most people aren’t concerned with statistics or return distributions, and prefer to think about investing in dollar terms, not percentages.

Ask someone if they can stand losing 25% of their portfolio over the span of one month and you will get an answer. Ask someone if they can lose $250,000 out of their million dollar nest egg and you might get another, depending on their past experiences and other internal factors.

This is why it’s much easier to define risk as the chance of meeting or not meeting specific goals. It becomes more real and tangible.

When we begin thinking about risk, we really need to consider two different pieces of the puzzle – risk tolerance and risk capacity. They are completely separate, although many don’t understand the difference.

Risk Tolerance

Risk tolerance is determined largely by internal factors, like attitude, personality, temperament, and genetic disposition. Risk capacity is primarily determined by external factors usually relating one’s financial situation.

I like to think of risk tolerance as the ability to withstand loss without selling out. In other words, how big of a drop in your portfolio can you stand without selling out and realizing huge losses? It’s highly connected with behavioral finance and emotional factors. Some people are very risk tolerant, others are highly risk averse.

Risk tolerance is often measured by risk questionnaires and personality typing. You have to be able to identify your own preference and create a portfolio that reflects your mental ability to withstand loss.

Risk Capacity

Risk Capacity on the other hand, is quite different altogether. Generally speaking, an investor’s ability to accept risk increases with their level of wealth, all else equal. If someone has sufficient wealth to meet future needs and expenses, that same person has a greater ability to accept risk with what is left over.

Of course, sufficiency is entirely dependent on lifestyle and consumption habits. A portfolio that can easily accommodate modest needs and a simple lifestyle will not sustain or provide the capacity necessary for the high expense celebrity.

This is why living simply can pay enormous dividends. A simple, low cost lifestyle enables one to take more risk without fear of going broke. Someone with $100,000 of savings, who lives on $20,000 per year, is in far better shape to change careers than someone who has saved the same amount, but whose expenses total $220,000 per year.

A Few Examples

Scenario 1: An Entrepreneur and Small Business Owner

Let’s say John started his business from scratch and has a large portion of his wealth tied up in an illiquid interest in the company (typical of small business owners). Let’s also say the company is in an industry that is somewhat volatile and in step with most market cycles. When the economy is good, business is great. When the economy slows, business slows. This is representative of stock market returns over time as well.

The result is that John has a low capacity for risk. His wealth is highly correlated with the stock market. It’s volatile, and illiquid. Please also note that John’s risk tolerance could be quite high and likely is if he resembles of the typical entrepreneur. John should base his investment choices on his risk capacity and avoid owning all a large portion of equities that will move in tandem with the overall market.

Scenario 2: The Stable Inheritance

Now consider Tom, a 30 year old government employee with a steady salary. Tom is also the beneficiary of a large, well managed trust that was left for him. The trust should last in perpetuity, and Tom enjoys his work and plans on working until 85. These two income streams more than cover Tom’s expenses.

Without knowing much more, we can assume Tom has a very high risk capacity. He should never need to touch his investment portfolio; therefore it makes little difference whether or not it is volatile in the short term. Tom just hopes it will grow over time so he can leave most of it to his children. Then again, Tom may have a very low risk tolerance, which would dictate a relatively safe investment portfolio to protect against losses.

How about you? What’s your risk tolerance and risk capacity?

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Author Bio: Jacob enjoys spending time with his wife and helping others secure a better financial future. When he is not blogging, he is completing his Ph.D in finance.