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April 27, 2020

Risk tolerance versus risk capacity…

Author: Marty Moore, CFP®

 

It’s been an unpleasant two months for investors.  During this period the stock market fell over 30% in record time.  It has since climbed back up about 27%, also in a very short amount of time.  (S&P 500; Morningstar, Inc.)

 

Does this mean the worst is behind us?  Maybe not? Probably not?  No one knows for sure.  Educated guesses can only be made and they are probably 98% guess and 2% educated at this point.  The economic ramifications of the purposeful icing of the economy will only be known in hindsight.  The closest historical reference we have is the Great Depression, and times then were so different, in so many ways, it really doesn’t offer much help in gauging how and when our current economy will recover.

 

I think one of the useful things we can all do now is consider how we’ve felt over this tumultuous period and how we’ve emotionally handled these unprecedented market swings.  No matter how seasoned of an investor you might be, it’s not easy to deal with this kind of extreme volatility.

 

Most investors have heard of the concept of risk tolerance.  As advisors, we talk about it a lot.  Risk tolerance refers to your ability to emotionally handle market turbulence.  What would you say is your risk tolerance?  Conservative?  Moderate?  Aggressive?

 

This is a difficult question to answer.  We tend to say we’re more on the aggressive side when things are going well and the market is moving higher.  Just the opposite possibly during rough markets like we’ve been in lately.

 

Another important concept that gets talked about less frequently is risk capacity.  Risk capacity refers to your ability to take on investment risk based on your personal financial situation.  If you are working and still early in your career, the reliability of your paycheck, your level of debt and your investment time horizon will factor in most heavily in assessing your risk capacity.  If you’re retired, your income need and time horizon relative to your assets is most important.

 

Those with a high level of risk capacity are in good position to generally weather a hit to their portfolio.  On the other hand, those with a low level of risk capacity may find that a shrinking portfolio may not be able to sustainably support the level of income needed.

 

How do you know what your risk capacity is?  Although it cannot be calculated with exactness, it can be evaluated and modeled in a way that can enable you to have a good understanding of your ability to financially withstand a big market decline.

 

As advisors, it’s important for us to know your risk tolerance, as best we can, and your risk capacity.  Knowing both allows us to feel confident that we have the right investment plan in place, one that accommodates both your risk tolerance and your risk capacity.

 

Risk capacity then is just as important as risk tolerance; perhaps more important.  If you think about it, having a good understanding of your risk capacity will enable you to sleep better at night knowing you’re in good position to handle a drop in your portfolio value.

 

A poor benchmark…

 

The stock market is a poor benchmark for our overall financial health and well-being.  To be sure, it has an impact on our net-worth, but we can’t measure our ability to achieve our financial goals through the daily price swings of the Dow Jones Industrial Average.  How often, however, do we tend to ‘live-and-die’ by what’s happening in the market day to day.  Our risk tolerance can surely be challenged at times.

 

So, let’s talk more about risk capacity as we have the opportunity.  We can do this conceptually and we can do this by conducting a detailed analysis.  It’s quite possible that by knowing your risk capacity you can be more comfortable with your risk tolerance.

 

In times like this, a little levity can go a long way…

 

During times of crisis, when we might be suffocating a bit from the weight of the problems of the world, I appreciate so much those who bring us a little sunshine and can put a smile on our face.  Here are some things I’ve come across lately that surely have brightened my day.  I hope they brighten your day too.

 

I’m getting a little low, can you boot one my way…

 

Home schooling is tough on parents…

 

But kids are learning amazing things while at home…

 

And here’s something we can all learn from…

 

 

And, finally, something you can’t help but feel good about…

 

As always, thanks for reading … and listening.

 

Marty

Market Update, Risk

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