Our personal comfort level with financial risk tolerance doesn’t change much over time, no matter how much information we have at our fingertips to ease concerns. At Versant, we use the FinaMetrica test to assess our client’s risk tolerance. (FinaMetrica has gained international recognition as the world’s best practice in evaluating financial risk tolerance.) But, what about assessing risk capacity? This Schwab article explains risk tolerance and risk capacity, how the two are related, and how they can differ from one another.
From Charles Schwab & Co., Inc.
What’s your likely response to a sudden 10% drop in the value of an investment? Would you sell all or some of your shares? Do nothing? Would you ever consider buying more?
Your answers to questions like these could provide important insights into your true risk tolerance, says Rob Williams, director of income planning at the Schwab Center for Financial Research.
Risk tolerance is an essential consideration when determining how to construct and maintain your portfolio over time. Unfortunately, investors aren’t always the best judges of their own appetites for risk, Rob notes.
For one thing, many people don’t consider the difference between risk tolerance and risk capacity, he says. Understanding how these two qualities differ—and how they interact in your life—can help you maintain an investment strategy that may enable you to better achieve your goals.
In the most basic sense, risk tolerance is your ability to stomach wide market swings in exchange for potential higher returns in the future.
But being able to accurately gauge your taste for risk can be tricky, Rob says. “When the market is doing well, you may think your risk tolerance is high. But when the market falls, you forget about that and your appetite for risk drops.” This is basic human nature, a phenomenon that psychologists refer to as loss aversion—the concept that losses trigger a greater emotional impact than equivalent gains.
That’s why investors often end up buying high and selling low—never a good strategy for success.
To get a better understanding of your ability to tolerate risk, it helps to look more broadly at the type of person you are. In fact, you might be surprised to learn that your risk tolerance really doesn’t change much over your lifetime, says Tyler Nunnally, U.S. strategist for FinaMetrica, which provides risk assessment tools for the financial services industry.
“Risk tolerance is a personality trait, similar to being an extrovert or an introvert,” he says.
That said, a person’s risk tolerance may vary across different areas of his or her life. Risk-taking behavior is divided into different domains, and there are no correlations between them. For example, some people who enjoy high-risk hobbies, such as skiing or rock climbing, may prefer very conservative investments. It depends on the person. And risk tolerance can also vary by gender; FinaMetrica data shows that among 67% of couples, men have a higher risk tolerance than their female partners.
What does shift over time is your capacity to take on financial risk—that is, your ability to withstand a financial shock. Your risk capacity can be influenced by a variety of financial factors throughout your life, including loss of a job, saving for your children’s education or a health crisis that leads to unexpected medical bills—changes that will likely lead you to revisit both personal and financial goals and your timeline for achieving them.
Thus, it’s important to understand how your capacity and your tolerance for financial risk may interact, Rob notes.
[mk_fancy_title tag_name=”h3″ size=”24″ line_height=”24″ font_weight=”inherit” letter_spacing=”0″ font_family=”none” margin_bottom=”0″ align=”left”]“Can” versus “should”[/mk_fancy_title]
A high tolerance for risk doesn’t mean you should take on more risk than necessary to achieve specific goals. Consider your time horizon. “If you have a goal of sending your kids to college, with a time horizon of 15 years or more, it’s likely that you’d have time to recover from volatility in the market—so you could take on more risk,” Rob says. “But as you move closer to your goal, your risk capacity may change because you may not have time to recover (links to http://www.schwab.com/insights/portfolio-management/protect-retirement-income-understand-sequence-returns-risk) from a market drop.”
Your level of wealth could also impact your capacity for risk. It may seem obvious that the more you’ve accumulated, the more easily you could weather a downturn in your portfolio without it affecting your goals or lifestyle. And while that’s perhaps true when you still have a long time horizon, you may eventually want to think about protecting your wealth for future generations, Rob notes.
[mk_fancy_title tag_name=”h3″ size=”24″ line_height=”24″ font_weight=”inherit” letter_spacing=”0″ font_family=”none” margin_bottom=”0″ align=”left”]Know thyself[/mk_fancy_title]
Charles Schwab’s Investor Profile Questionnaire can help you understand your tolerance for risk—and also guide you in determining your risk capacity when constructing a portfolio. Rob recommends revisiting the questionnaire once a year when reviewing your investments and reconsidering your asset allocation, given how your life may have changed over the past 12 months. Ask yourself whether your goals, priorities or time horizon have shifted.
Going through that exercise, you may find that you have a general level of risk tolerance but a different risk capacity for each goal.
For example, if you have an emergency fund, it’s hard to predict when you’re going to need that money—so it shouldn’t be invested aggressively, Rob says. If you’re saving for a down payment on your first home, your capacity for risk will depend on when you plan to make the purchase. In your retirement account, you should gradually reduce your risk profile as retirement nears, without eliminating risk altogether.
To manage different goals, Rob suggests dividing investments into multiple buckets with different allocations. If you’re someone who enjoys excitement in your portfolio, consider taking those extra risks in a separate account using assets that you can afford to lose, he says—in other words, where you have a greater risk capacity.
[mk_fancy_text color=”#444444″ highlight_color=”#ffffff” highlight_opacity=”0.0″ size=”14″ line_height=”21″ font_weight=”inhert” margin_top=”0″ margin_bottom=”14″ font_family=”none” align=”left”]Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Diversification and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs, and when rebalancing a non-retirement account, taxable events can be created that may affect your tax liability.
Disclosure: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Versant Capital Management, Inc.), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Versant Capital Management, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Versant Capital Management, Inc. is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. If you are a Versant Capital Management, Inc. client, please remember to contact Versant Capital Management, Inc., in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of the Versant Capital Management, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.[/mk_fancy_text]
