I couldn’t say no. My 9-year-old son and his buddy challenged me to a game of basketball in the driveway, and they insisted on the goal being lowered to 7-1/2 feet. Needless to say, I was going to show them a thing or two.
All it took was my son undercutting my legs on a thunderous dunk attempt to remind me of the difference between my tolerance for risk and my capacity for risk.
On the surface, I have no problem risking a little bit of my health and wellness to show my son what’s left of my athletic prowess. That’s my risk tolerance. It’s primarily rooted in my feelings about what I’m willing to do, and what I’m willing to put up with when my plan goes awry.
My capacity for risk is based on how much risk I can afford to take. As my life flashed before my eyes, and my driveway drew those eyes closer, I quickly realized I had a capacity-for-risk problem. Plain and simple, I cannot afford to seriously hurt myself right now. I have way too many responsibilities. Could I afford to get hurt playing random basketball games when I was in my 20s? Of course. And I did. I have the surgery bills to prove it.
Most people understand the concept of risk tolerance, and reasonably employ the concept to ensure a healthy investing experience. However, most people don’t spend enough time scrutinizing how much capacity for risk they have.
To better understand the relationship between tolerance and capacity, let’s examine the realities of two seemingly similar investors.
Hanna is 25, single, and has found cryptocurrency satisfies her high risk tolerance. Elizabeth also loves crypto and has a high risk tolerance, too, yet her family structure is a bit different. She’s 52 years old and has a giant mortgage payment and three kids in college. Hanna has a higher capacity for risk than Elizabeth does. Hanna can afford for things to go wrong, and she has the bandwidth to pick up the pieces. Elizabeth has a very small margin for error, no matter what her risk tolerance is.
Just because you’re willing to take risks, and you’re comfortable with suboptimal outcomes, doesn’t mean you should be. Risk tolerance is about your feelings; risk capacity is about math.
Let’s look at this mathematically. If your retirement plan means you can’t lose more than $50,000 off your current value in the next 24 months, your investment allocation must reflect this reality. This has nothing to do with what you’re willing to tolerate.
This is a good lesson outside of investing, too. For instance, I’m at a crossroads between my tolerance of risk associated with eating incredibly indulgent and unhealthy foods, and the capacity I have for those same risks.
The exact same bold risk tolerance that allows you to grow the assets you need to grow in order to successfully retire can be your downfall if you don’t keep an eye on risk capacity.
To make sure you’re not ignoring risk capacity, start by examining the goal at hand, and what it takes to accomplish that goal. For instance, if you are trying to ensure you have $150,000 of annual retirement income at retirement, and your investments are to provide $100,000 of that annual income, you need to make sure you’re not taking more risks than necessary. If you’re currently averaging a 13% rate of return, investing in accordance with your risk tolerance, and you need only a 6% rate of return to fully accomplish your goals, then you must deeply examine whether you’re taking too much risk.
It’s a jarring idea, frankly. Why pull back your investing strategy when it’s going so well? Because the goal is the goal, and your tolerance for risk shouldn’t dominate your capacity for taking risk. Don’t mistake this for “getting conservative.”
My hope is that you have a conversation with your financial adviser about aligning your risk tolerance and your risk capacity. Ask her what the lowest rate of return is that you need to average here on out to accomplish the goal. And then discuss whether exceeding the goal actually provides you any additional value. Because seeking additional return often exposes you to greater risk of missing the goal.•
Dunn is CEO of Your Money Line powered by Pete the Planner, an employee-benefit organization focused on solving employees’ financial challenges. Email your financial questions to firstname.lastname@example.org.