By Massi De Santis
Your asset allocation represents how you divide your wealth across different investments, and can be the single most important element of investment success. Arriving at the right asset allocation requires the evaluation of a number of factors that are unique to each investor. With my clients, I conduct this evaluation within a framework called the Investment Policy Statement or IPS. This article is one in a series of articles discussing the key elements of an IPS, and how to put them into practice for your investment plan. We have covered how goals should inform your asset allocation, so we start here with risk capacity.
What is Risk Capacity?
The risk level of your portfolio, typically captured by the split between stocks and bonds, is a key determinant of the success of your plan. However, finding the right level in practice can be a challenge. Most investors have heard and used the concept of risk tolerance to help them gauge their preferences for risk. A less common concept is the concept of risk capacity. However, risk capacity can be more intuitive and just as important as risk tolerance in determining the right risk level for your portfolio.
Here is the difference between risk tolerance and risk capacity: Risk tolerance is your willingness to take risk. It is a psychological aspect that can affect your investment behavior. If you take too much risk, short-term fluctuations could generate emotions of anxiety, fear, or regret that may lead to suboptimal investment decisions. Too little risk can have similar effects. In contrast, risk capacity is a measure of your financial capacity to take risk. As such, it takes into account the nature and horizon of your goals, your sources of income, and all your available assets. Take too much risk relative to your risk capacity, and you may fail to achieve some important goals.
Elements of Risk Capacity
Increasing risk in your portfolio can enhance your returns and help you achieve your goals faster or with lower savings. However, risk comes with a downside, which is the possibility that your return may be lower than expected. Here is the question we are trying to answer with risk capacity: Can you withstand a bad return scenario and still achieve your most important goals?
Risk capacity depends on the horizon of your goals and needs, your sources of income, and your accumulated assets. This is why in a risk capacity questionnaire, advisors ask questions about the nature and priorities of your goals, your cash flow needs, and your expectations about income, and the ability to adjust your savings. Let’s review these aspects in turn.
Your Goals and Their Time Horizon
We start with the goals and time horizon because we can use them to provide some general guardrails about asset allocation. If your horizon is short, say less than five years, the allocation to risky assets like stocks should be minimal or nil. For intermediate goals of seven to 10 years, a moderate allocation to equities can be beneficial. For longer term goals the allocation to stocks can increase quickly and can easily be the largest fraction of your investments. There are two reasons for this pattern of time horizon and allocation to stocks. The first is that over long periods of time, the likelihood that stocks will yield negative returns declines. The second, and more important reason is that a long horizon gives you greater flexibility to make adjustments along the way. As a starting point for your asset allocation, check out our prior post to learn how to use your goals in your investment allocation, and set some starting values for each of your goals.
Income and Risk Capacity
One of the questions I ask my clients is their expected income over the next few years, and whether they think they can make up for losses with additional savings. A good and stable income usually gives you the flexibility to make up for potential losses with additional savings in the future. That in turn gives you a greater ability to take more risk with your current investments.
The source and nature of your income matter too. For example, if you are a business owner, you probably have a lot of your capital invested in the business, and are facing a risk that is unique to you and hard to manage. This unique risk reduces your ability to take risks with your portfolio. Similarly, if your income is lumpy, maybe because a large part comes from annual bonus payments, you may need to build a bigger buffer against unexpected expenses, which reduces your risk capacity.
The same principles apply to a retiree. If a large fraction of your income comes from fixed payments like Social Security and/or a pension, you may be able to take more risk with your investments. If you rely on your saved assets for income, your ability to take risk is reduced. In this case you may want to build some flexibility in your spending habits.
Start with Your Budget
Whether your income allows you to take more or less risk ultimately depends on your needs and goals. So, the first thing you can do is to gauge your flexibility in terms of spending and saving by outlining your cash flow needs and your potential savings with a budget. Then compare the cost of your goals with your savings plan.
For example, suppose you have saved $30,000 so far for a goal of $90,000 to $100,000 to start a business in five years (it’s always best to start with an acceptable range for your goals) and you budget that you can save $1,000 a month for the next five years. Will you achieve your goal? How much risk can you take?
You can use a savings calculator to test your plan and gauge your risk capacity. With an annual return of about 1%, the $1,000 per month plan will put you close to $93,000 at the end of five years, right around your goal. I choose 1% here because it’s close to what you can expect from five-year Treasuries these days. If $1,000 is all you can afford to save every month, you can’t afford to take any risk, so you may want to avoid stocks altogether.
However, if you can make up for low returns by increasing your savings in years when your returns are lower than expected, say increasing your savings to $1,100 or $1,200 per month, you can take more risk. The upside of the risk is that if the higher potential returns are realized, you can achieve your goal earlier than expected.
A good way to gauge your risk capacity is to explore potential outcomes under a reasonable range of returns consistent with the risk level you are considering. For example, suppose you are considering a 60/40 allocation. In bad scenarios, a 60/40 portfolio can have negative returns over five year periods, and close to zero even over 10 years. Knowing whether you can deal with the bad scenarios determines your risk capacity. Do a bit of research to understand the range of potential outcomes for different levels of risk. If you work with an advisor, ask them to educate you on the risk-return tradeoffs. For income goals, you can use an income calculator, like this one. If doing this for all your goals seems overwhelming, start with your top priority goals. You can learn a lot about your risk capacity by just applying this principle to one of your main goals.
The Role of Your Accumulated Assets
If you have a good amount of accumulated assets, you are likely getting relatively closer to achieving your goals, both in terms of horizon and dollar values. Your accumulated assets are becoming a more important source of funds to achieve your goals relative to your future income and savings. This means that your risk capacity is declining, because future adjustments may not be enough to overcome large losses. A typical example is an employee over the last ten to five years before normal retirement age. But the concept applies generally to any goals. When you have accumulated a good amount of assets and are getting closer to achieve your goals, why take unnecessary risks?
Putting it together
Risk capacity may require a bit more work than a risk questionnaire, but has the advantage of being more intuitive and of practical use. Here is a process you can use to gauge your risk capacity and use it in your asset allocation.
1. Start with defining your goals and investment horizon, and select a plausible starting level for your asset allocation for each goal.
2. Derive how much you think you can save towards your goals. Do this for each of your main goals, in order of importance.
3. Use our considerations about your income sources, the flexibility about savings, and your accumulated assets to refine the asset allocation in step 1.
4. Optional: Use a calculator to help you estimate how much you need to save vs how much you plan to save, and evaluate a few bad scenarios. How much room do you have for adjustments?
I put step four as optional because you may not be comfortable interpreting the results from a calculator. If so, you can skip that part. A plausible starting point based on your goals and time horizon, your budget, and a few considerations about your income and level of assets can go a long way. You are now ready to take a risk tolerance questionnaire and further refine your allocation.
Like most decisions in personal finance, asset allocation comes down to making tradeoffs. Different tools like a risk tolerance assessment, goal projections, and risk capacity assessments allow you to evaluate the tradeoffs from different angles and help you find what works best for your goals and your behavioral attitude towards investment. Given the importance of asset allocation in a financial plan, it is well worth the effort.
About the author: Massi De Santis
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
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