Risk Tolerance Vs. Risk Capacity – And What it Means for Your Investments
All investors should understand the concepts of risk tolerance and risk capacity in order to develop a comfortable financial plan with their advisor. But understanding how these two concepts work together is particularly important for high-income individuals in Northern California, as the more money you have, the more money you can lose.
Risk tolerance and risk capacity are often confused. Unnecessary risks are commonly overlooked. As a Sonoma County wealth advisor for many years, I have unfortunately seen this happen many times. And it can have a big impact on your retirement and financial planning goals.
To help reverse this trend, here’s a brief overview:
First, What Is Financial Risk?
Portfolios are comprised of various asset classes, and each asset class carries its own level of risk. Most portfolios carry a mix of cash instruments/bonds and stocks to manage risk.
Cash instruments and bonds are relatively low risk, because the interest accruing is fairly steady. The principal in cash instruments like Certificates of Deposits (CDs) doesn’t fluctuate at all. In bonds, while the principal can fluctuate due to changes in interest rates and other factors, fluctuations are fairly minimal, especially compared to stocks.
But the downside of the cash instrument/bonds asset class is that returns are also very low. Currently, interest rates are at a historical low, which means that interest on this asset class is also at historical lows. The value of a portfolio comprised of only cash and bonds would not keep pace with inflation, which currently runs at about 2 to 3 percent annually.
Stocks, on the other hand, offer much higher returns.
Stock price appreciation in the broad-based S&P 500 has increased roughly 10 percent annually, on average, over the past near-century.
However, stocks also carry significant risk. Stocks fluctuate. In certain periods, they can lose a significant amount of their value. This can, of course, pose significant risk to people in certain groups, such as people approaching retirement in just a few years.
Generally, portfolios are allocated with a certain percentage to cash/bonds and a certain percentage of stocks. The combination of cash/bonds and stocks in portfolios is intended to maximize the stability of cash/bonds to minimize risk as much as possible, while the stocks maximize returns but also add an element of risk.
The question is, what’s the right combination for you? This is where many investors make mistakes.
Are you taking the right amount of risk in your portfolio? Schedule a free, no-strings-attached conversation with the team at Montgomery Taylor Wealth Management to find out.
What is Risk Tolerance?
Risk tolerance refers to an individual’s comfort level with risk in their portfolios. Factors such as age, income, goals and profession can all play a role in one’s risk tolerance. Everyone’s risk tolerance is different.
But don’t get confused here. Just because you may like to take risks in your everyday life – if you enjoy skydiving or other extreme adventure sports – doesn’t mean you like taking risks with your money. Some people may be very comfortable with the fluctuations of the stock market. Others may literally lose sleep over the fact that they are (or could be) losing a significant part of their hard-earned nest egg.
Your risk tolerance can also change over time due to different factors. Plunges in the stock market can make relatively confident investors develop more fear of risk. A long bull market, on the other hand, can decrease any discomfort with risk.
Your financial advisor should discuss your comfort level and risk preference with you to determine an accurate tolerance level. This is an important factor in your financial plan, so a quick, online, 5-question risk assessment isn’t typically enough to give you a realistic answer. Instead, talk with a financial about your specific situation, your fears, your plans for the future and your retirement and financial planning goals to determine a risk level that really works for you.
What Is Risk Capacity?
Risk capacity is the amount of risk an individual needs to take to achieve their goals. This isn’t the level you’re comfortable with; it’s how much risk is necessary to reach your goals.
If your goal is to maximize your portfolio returns to achieve a high amount of retirement fund savings, for example, your portfolio needs sufficient risk capacity to achieve that goal. If your goal is to live comfortably in retirement with your portfolio throwing off a certain amount of income every year, your portfolio needs sufficient risk capacity to do that.
If your risk capacity and risk tolerance are out of alignment, you and your financial advisor may need to modify your portfolio. This can affect both your retirement and financial planning goals.
What Are Unnecessary Risks You Should Avoid?
While it’s important to understand your risk tolerance and risk capacity, there are also unnecessary risks that investors should be aware of – and avoid, if possible.
Timing the Market
Market timing refers to the practice of making moves in your portfolio, assuming you can predict the future direction of the stock market.
Individuals may, for example, decide to sell stocks after the stock market plunges, on the belief that a bad day or set of days, indicates that the market is on a downward trajectory. Or, they may assume a long stretch of upward moves means that they no longer have to pay attention to the possibility of downward moves.
In either case, market timing doesn’t work. That’s why it’s risky. Every day in the stock market is a new day. A long string of down days can be followed by upswings with no advance warning. And a long string of up days can be ended with a plummet, with no advance warning. Just look at 2020.
If you sell stocks because the market falls, you risk losing out on upward moves, to say nothing of dividend reinvestment. If you assume you don’t need portfolio risk management because of a bull market, you can be unpleasantly surprised when the value of your investment drops.
Don’t confuse market timing with what we call “tactical tilt.” In our investment management, we
utilize a proprietary risk management strategy, we call tactical tilt, to increase and decrease stock
exposure as the economic cycle changes.
Handling Your Investments On Your Own
Handling your own investments can also be risky. Some people may overreact to market conditions or make unsupportable assumptions, and some may not fully understand the complexities involved in portfolios.
Emotions can run high when it comes to your hard-earned money, but emotions have no place in investing. A financial advisor can help you stay focused on your long-term goals and make educated decisions opposed to emotional reactions.
Setting and Forgetting
Portfolios should be monitored regularly to ascertain investments are aligned appropriately with goals and to keep track of any effect changing conditions have on the investment choices.
They should also be rebalanced at least once per year. The composition of a portfolio changes with market conditions. If stocks have had a good year, for example, the stock percentage of a portfolio will grow much larger, and if they’ve had a bad year, the overall percentage will fall. Rebalancing ensures the percentage of each asset class is a choice, not just a result of returns.
Not Establishing a Plan Until Later
It’s important to establish a financial plan as early in life as possible. Financial goals are more easily reached if you know and can plan for them well in advance. Financially, investments have a longer time horizon over which your assets can appreciate.
While high-income individuals can catch up on their goals and investments, the lack of a longer time horizon in which their investments can appreciate constitutes a form of risk, because short-term portfolios will not have as much time to appreciate as longer-term ones.
Putting it All Together
If the roof of your home was leaking, you’d likely turn to a professional for help. The same should be true with your investments. Tax laws change constantly. Estate planning rules change. The market is volatile.
The Sonoma County wealth advisors at Montgomery Taylor Wealth Management can provide you with integrated, complete financial advice to help simplify your life and maximize your opportunities. Contact us to see how we can help.