Understanding Risk Is Key to Investing

March 14, 2014
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risk toleranceEach individual has a distinct risk tolerance level. Unfortunately, the standard questionnaire from financial planners may not paint an accurate picture of one’s risk preferences as it is not tailored to reflect every aspect of an individual’s financial life. While words like “tolerance” and “capacity” are used reciprocally by financial planners, the fact is that these words have different meanings to different people.

The term “risk capacity” is used to measure one’s financial ability to sustain risk. In the context of a practical financial arrangement, risk capacity considers one’s asset base, withdrawal, and liquidity needs in a given time period. An example of a very high risk capacity portfolio would be withdrawing $30,000 annually from an asset base of $1 million starting 15 years from now to fund periodic retirement payments. In this scenario, the portfolio will have sufficient means to sustain the retirement goals even if it experiences consecutive years of underperformance with the designated investment vehicle.

On the other hand, if the same portfolio is only worth $500,000 and needs to fund retirement withdrawals of $40,000 annually from the next year onward, then this portfolio has a considerably lower risk capacity. If the investment returns suffer within the next twelve months, even a slight variation from the expected rate, the periodic retirement withdrawals will have to be adjusted.

Risk capacity represents the ability to sustain a decline in the expected rate of return from an investment, such as a plunge in the stock market or a low interest rate from bond investments. This will not affect one’s current or future lifestyle or quality of life. Risk tolerance measures one’s willingness to face such consequence in the first place. Risk tolerance is much more personal than financial, as it measures perceived risk in terms of emotional attachment to the investment.

Financial advisors need to be very cautious about distinguishing these two terms for their clients. They should not impose their own risk tolerance level onto the client by asking the question in a particular manner, framing decisions, or offering non-verbal cues.

While risk capacity and risk tolerance are not interchangeable, together they establish a foundation for creating a risk-based portfolio. It’s important to partner with an advisor who offers a personalized financial planning approach that allows you to understand what risk means to you.

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Copyright © 2017. HFG Wealth Management, LLC. Investment advisory services offered through HFG Wealth Management, LLC – An independent Registered Investment Advisory firm registered with the SEC. Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Therefore, any information presented here should only be relied upon when coordinated with individual professional advice. [ more disclosures ]