One of the most overused words in the investment management space is "risk tolerance". It is almost purported that those who clearly know their risk tolerance are somehow miles ahead of everyone else. Furthermore, once a risk tolerance is clearly defined, it is believed that the right investment portfolio can be selected for an Investor. I do not agree.
Risk Tolerance and Risk Capacity
I define risk tolerance as the emotional side of risk. In other words, the amount of risk you are willing (or wanting) to take in a situation. While risk capacity in the simplest of terms is the amount of risk one needs (or is able) to take in order to reach a goal or outcome.
Let's meet Nathan, he prefers to spend his Saturdays rock climbing or doing other risky endeavors. He believes life is all about taking risks, living on the edge, and embracing the uncertainty of life. Nathan's brother Mark is unlike Nathan in many ways. Mark prefers to keep his feet on the ground as he has never identified himself as a risk taker. Nathan and Mark are brothers and both are engineers earning a healthy income.
One day, a friend of the two brothers noticed something quite interesting. While the two brothers may have similar jobs and income, their financial situation is entirely different. Nathan the risk taker, about five years ago married the love of his life. They have two kids together and because of a family decision, the wife decided she would stay home with the kids. Nathan is the sole income earner for the household. Mark on the other hand is not married and has no plans to do so. In fact, he has from a young age mentioned his desire to not marry and instead live a quiet independent life. Not only that but Mark was friends with a person who died and due to a series of fortunate events for Mark, he inherited over 3 million dollars. Nathan on the other hand is still relatively new in his career and just starting to build his wealth nest egg.
The friend noted how something seemed amiss, and that if their roles were switched, things would make a lot more sense regarding their preferred levels of risk. The reality was as the friend pointed out that Nathan while having ample risk tolerance had little to no risk capacity. While Mark had little risk tolerance but ample amounts of capacity for risk. See Nathan and his whole family are relying on Nathan and his ability to generate income for the household. The ability for Nathan to continue generating income Monday through Friday is pivotal to the success of the family. An event that would lead to the death or disability of Nathan would impact him and the family significantly.
While Mark, who also generates income Monday through Friday is simply doing so because he prefers to keep his mind sharp. He does not need the income, but if something does happens to him, there is no one relying on his ability to generate income. Even if Mark becomes disabled, he will have the ability to continue living a lifestyle with the dividends and interest generated from the 3 million dollar portfolio. Nathan and his family on the other hand are not be so fortunate.
The friend commented how their risk capacity was really the more important factor in their situations and should be the primary driver for how they live life. He explained how Mark has the ability to take risk, while Nathan on the other hand, needs to reassess how he lives life and the amount of risk he takes. Does this mean risk tolerance is completely usurped by capacity, no but what it does mean is risk capacity should always lead the conversation and tolerance can fill in the cracks. Does Nathan need to change his lifestyle completely, and stop doing the things he loves, no not necessarily, but he better implement ways to increase his capacity.
After the friend shared these things with them, the brothers asked how they could adjust their lifestyle to meet their risk capacity. For Nathan, the friend shared how there were a variety of ways of increasing his risk capacity for him and his family. Some of those ways include, reducing the amount of risk he takes, getting life and disability insurance on Nathan, and/or have Nathan's wife start to earn a wage so she too can support the family financially. Mark on the other hand, doesn't need to change anything, but if he wants to increase his risk tolerance, he can easily do so, and without adverse effects to himself financially.
How does this impact my Investment Portfolio?
If one simply builds a portfolio based around risk tolerance and neglects risk capacity, they are are setting themselves up for possible catastrophic failure. Either they are too conservative, and never actually grow their wealth, or they are too aggressive and they end up losing the wealth they have accumulated.
How do you find your financial risk tolerance? Simple, complete a risk questionnaire and ask your friends and family how they would define your comfort with risk on a scale from 1 - 10. Finding your risk capacity however is a bit harder. The way to do that is to develop a financial plan factoring in all of the various components and assumptions for your future. If done correctly and thoroughly, your risk capacity will reveal itself and then you can adjust your investments and life around that capacity. I believe by doing this you simply being a good steward of your wealth. There are some free tools out there for building a financial plan. Check out the resources page at RetirementGuy.org
In summary, if you are focused on maximizing your financial and life goals and want to ensure success long-term, make sure to align your risk tolerance with your risk capacity.