Risk Tolerance, Risk Capacity, and Risk Alignment: How to Take on the Right Level of Risk

When creating a diversified portfolio, understand your risk tolerance and risk capacity.
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By Marguerita M. Cheng, CFP

When uncertain economic situations arise, such as the COVID-19 pandemic, they send fear into investors' hearts, especially those close to or who are in retirement. The risk of losing their money stares them in the face, and they wonder what the right step to take is.

Marguerita Cheng

Marguerita Cheng, CFP

In such situations, investors tend to make bad decisions, informed by the present uncertainty rather than by their financial plan.

Benjamin Graham, the father of value investing, said, “Individuals who cannot master their emotions are ill-suited to profit from the investment process." Charlie Munger, vice chairman of Berkshire Hathaway, puts it this way: “A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. You need to keep raw, irrational emotion under control.”

One way to avoid such situations is for investors to define their risk profile and construct their financial plans according to their risk profile. To do this, they need to understand risk tolerance, risk capacity, and how to achieve risk alignment.

Diversification, Investment Portfolio, and Risk

The development of the Modern Portfolio Theory (MPT) was a great reminder of the importance of risk in investing. While returns are important, every level of return comes with a level of risk.

Consequently, to minimize risk, you must construct a diversified portfolio of assets. By creating your portfolios with negatively correlated assets, you are not exposed to all the unsystematic risk of a single asset. The MPT shows us that a diversified portfolio's risk is less than the risk of a single asset in that portfolio.

However, once you decide to diversify your investments across a range of asset classes (stocks, bonds, real estate, for example), you must choose an asset allocation formula. Should you invest 50% in stocks and the remaining 50% in bonds and real estate? Should it be 80% in stocks or 80% in bonds and real estate?

Stocks produce higher returns with higher risks, but bonds produce lower returns with lower risks. Real estate is closer to stocks in the risk-return dynamics. Closer to bonds are other fixed-income securities like certificates of deposit. How then should you compose your diversified portfolio?

To decide, you need to understand your risk tolerance and risk capacity.

Risk Tolerance

Risk tolerance is a measure of how much risk you are willing to take on. Generally, there are three types of investors: conservative, moderate, and aggressive. The level of risk tolerance increases as you move from conservative to aggressive.

Factors like age, income, financial goals, and psychological and emotional conditions influence your risk tolerance. For example, a 60-year-old closer to retirement is generally more conservative than a 25-year-old who just entered the workplace

An individual with a stable job in a stable industry earning $100,000 may be a moderate or aggressive investor. In contrast, an individual with unstable income in an unstable industry earning $50,000 will be, generally speaking, more conservative.

A couple who wants to pay for their children’s college tuition in two years will be more conservative than a couple who is not planning to have a child in the next seven years.

However, we must stress that there are emotional and psychological factors that also influence risk tolerance. Some people are naturally risk-averse, while others are risk-seeking. Consequently, the person with the $50,000 job in our example may like to take on more risk than someone with a $100,000 income if the former is normally risk-seeking.

The point of the above is that risk tolerance is subjective. While there are factors that inform it (age, income, financial goals), they are not determinative given the role of emotion and psychology.

Many financial advisors have defined risk tolerance as the amount of risk you can take and still sleep at night. How much risk are you comfortable with? What level of risk won’t keep you awake at night while refreshing your portfolio dashboard?

Risk Capacity

However, the level of risk you are willing to take is not the same thing as the level of risk you should take. Risk capacity is the measure of the latter. It’s an objective determination of the level of risk you should be taking in your portfolio to achieve your financial goals.

Factors like timeframe/time horizon, cash flow, income requirements, debt, insurance, and liquidity will determine your risk capacity.

To determine your risk capacity, first consider how much income you will need at retirement. Secondly, determine how many years you have until retirement (based on your preferred retirement age). Third, evaluate your current income levels and savings rate (what percentage of your income you are saving). Fourth, identify the money you currently have in retirement savings.

With the aforementioned information, you can determine the rate of return you need to earn on your savings to meet your retirement income goals. Your financial advisor can help you with the calculations, or you can use a retirement calculator.

The rate of return you need to achieve your retirement goals will then determine the level of risk you should take in your portfolio. That is your risk capacity—the objective level of risk you should take.

If you are already retired, you need to consider how much you have in retirement savings, retirement income, the withdrawal rate, and how long you expect to continue making those withdrawals. The above data will give you the rate of return you need, which will determine your risk capacity.

Comparing Risk Tolerance with Risk Capacity

So, what should determine your asset allocation formula? Risk tolerance or risk capacity?

The problem is that for many people, risk tolerance and risk capacity don’t align. Some people have low risk tolerance but high risk capacity and vice versa. There are four possible situations when comparing risk tolerance and risk capacity:

Low-risk tolerance and low-risk capacity: These are investors who don’t want to take on much risk and don’t need to. A good example is a retiree with a generous pension and Social Security benefit and, therefore, does not need as much rate of return as someone without a pension or Social Security benefit. Consequently, they have a low risk capacity. If they are also unwilling to take more risk than they need to, they also have low risk tolerance.

High risk tolerance and low risk capacity: These are investors who want to take on high risk but should not. For example, a married accountant may enjoy the excitement of investing in the stock market (purchasing individual stocks)—high risk tolerance—but needs to pay cash for a child’s college in two years.

Another example is a lawyer nearing retirement who only needs 7% returns to achieve their retirement goals but is interested in buying the stocks of some companies with good potential. She does not need to take much risk to meet her goals (low risk capacity), but her sense of adventure (and a desire to be invested in the next Amazon) is driving her to take on more risks (high risk tolerance).

Low risk tolerance and high risk capacity: Some investors don’t like much risk, but they actually have to assume risk. For example, some people start their retirement savings very late, and they need a higher rate of returns to meet their retirement goals—high risk capacity. However, the fear of losing their money and the absence of pension make them unwilling to take on that level of risk (low risk tolerance).

High risk tolerance and high risk capacity: Some workers who started their retirement savings late (and, therefore, need a higher rate of return)—high risk capacity—are also willing to take on the risk required to meet their retirement goals.

Risk Alignment

Risk alignment occurs when your risk capacity and risk tolerance are the same. In the examples above, there is risk alignment in the first (low risk tolerance and capacity) and fourth situation (high risk tolerance and risk capacity).

The goal of every investor is to have such risk alignment, where risk tolerance equals risk capacity.

However, there are many people in the second and third situations. In those situations, to achieve risk alignment, one of two things have to happen:

Change in risk capacity: In situation 2 above (high risk tolerance and low risk capacity), the married accountant can aim for a more expensive college, so the rate of return needed on college savings is higher—meaning a higher risk is needed. The attorney who needs only 7% returns to retire can set a higher retirement goal to achieve higher risk capacity and align risk tolerance.

In situation 3 (low risk tolerance and high risk capacity), the workers who started retirement savings late can reduce their retirement income goals so that the needed rate of return is lower and low risk tolerance can align with low risk capacity.

Change in risk tolerance: The other option is to change risk tolerance. In situation 2 (high risk tolerance and low risk capacity), the accountant can reduce their risk tolerance by considering what would happen if they lost their child’s college savings in search of higher returns. The mother who wants to be an investor in the next Amazon can consider that 45% of new businesses fail within the first five years.

In situation 3 (low risk tolerance and high risk capacity), the investors can consider how important it is to have quality of life and enjoy retirement

Conclusion

Aligning your risk tolerance and risk capacity will help you stay sane and confident even in uncertain economic situations. Instead of acting on emotions, you will be acting in line with your risk tolerance and capacity, and according to the financial plan created because of them.

Once you overcome the emotional reactions to present economic realities and embrace a sound financial plan, you will be on the way to achieving your financial goals.

Risk alignment is one important reason everyone needs a Certified Financial Planner®. A CFP® professional will help you align your risk tolerance and capacity so you can choose the right asset allocation formula. Your CFP® professional will help you decide if what you need is a change in capacity or tolerance. Don’t leave your finances to chance.

About the author: Marguerita (Rita) Cheng, CFP

Marguerita (Rita) Cheng helps educate the public, policymakers, and media about the benefits of competent, ethical financial planning. As a Certified Financial Planner® professional and chief executive officer of financial advisory firm, Blue Ocean Global Wealth, Rita helps people meet their life goals through the proper management of financial resources. She is passionate about helping them navigate some of life’s most difficult issues—divorce, death, career changes, caring for aging relatives—so they can feel confident and in control of their finances. Rita volunteers her time as a SoleMate, or charity runner for Girls on the Run, raising money to win scholarships for girls. She is also a coach for 261Fearless, a global supportive social running network that empowers women to connect and take control of their lives through the freedom gained by running.