Do You Know Your Investment Risk Capacity?
To download a six-page summary explaining risk capacity, click on the following link:
Have you ever heard the term “Risk Capacity”?
Chances are very high that you have not. Why is that?
Most financial professionals focus on the more commonly known term of “Risk Tolerance.”
- Risk Tolerance is someone’s personal attitude about investment risk, e.g., how comfortable someone is with dramatic losses in their investment portfolio when the stock market goes negative.
- Risk tolerance is emotion-based.
What is Risk Capacity? It’s a bit tough to define so I’ll give you a few definitions:
A classic definition is the amount of risk you need to take in order to reach your investment goals (either asset accumulation, income in retirement, or both).
A different way to define risk capacity is whether an investor is in a position to assume risk and if so, how much (will negative returns adversely affect the investment goals/objective).
Risk capacity is an emotionless risk metric that only looks at the financial well-being of someone and then mathematically determines their ability (capacity) to take investment risks.
The following are the traditional items you’d look at to formulate someone’s baseline risk capacity:
1) What assets do you currently have to reach your financial goal(s)?
2) Are you fully employed, part-time, unemployed, or retired?
3) What is your annual income?
4) How much is in your emergency fund?
5) What are your future financial commitments?
6) When do you need access to your money?
Those who start with or have more assets, those who have full-time jobs and ones that are high paying, those who have more in their emergency fund than those who do not, those who don’t have minor children in the house and the expenses that go with them, and those who can wait longer to access to their retirement funds will have a higher risk capacity.
Why does risk capacity matter and how is it used?
Risk capacity, if used properly by a financial planner or insurance agent, will help the advisor determine what investments and/or insurance or annuity products are most “suitable” for clients.
Without incorporating the use of risk capacity, it doesn’t mean that recommendations from an advisor will be terrible, but they will not be as good as they could be.
Since most people would prefer that any advice they receive be as good as it can be, I would recommend that everyone seek out an advisor who has the ability to incorporate risk capacity into their planning.
Why don’t more advisors use risk capacity when giving advice?
One main reason is that most investment risk software doesn’t deal with risk capacity. We happen to use investment risk software that incorporates both risk capacity and risk tolerance and thinks our clients are better off because of it.
Want to know your personal risk capacity and risk tolerance?
If you do, all you need to do is click on the following link and take a few minutes to fill out an online questionnaire. Afterward, you will be given your own personal risk score that incorporates both risk capacity and risk tolerance.