How to Plan for Risk in Your Portfolio by Knowing Your Tolerance and Capacity
Summary: Tolerance and capacity are two ingredients of risk when it comes to investments and retirement planning. We look at what they are, and what kind of critical impacts they can create when planning for your golden years.
When we think about recipes for well-funded retirement plans we often start with some basic concepts. One of them is that investments are at the root of preparing for our post-work years. Packed into our investment portfolios, however, is a separate consideration — one that's crucial to getting retirement right.
It's the concept of risk.
Planning for one's golden years requires that we understand exactly how we feel and react when it comes to how much risk we decide we can take on, and how much of it we have to take on to retire well. And so, let's look at two key elements of risk and break out some strategies for assessing and preparing for your future in ways that allow risk to work best for you.
Tolerance and Capacity: Two Sides to the Investment Story
Risk is at the heart of every portfolio. The effectiveness of what we do with our assets relies upon it.
First and foremost, risk is defined as the possibility that something unpleasant will happen (in this case, it happens to the investments we make). A bear market might set in. A stock's value could crash. The something unpleasant, then, amounts to the positive change we want — the value of our assets increasing — being replaced by negative change … our assets diminish instead of grow.
If this happens in a way, or at a time, that affects how we can draw upon our retirement income, then we maybe have to wait on a trip we wanted to take to see loved ones. Or, worse, we can't write the check for our car payment or mortgage. The outcomes of risk, in such cases, are not pleasant ones at all.
So, to better understand this important factor, let's put a frame around risk. We'll use two ideas to do so: tolerance and capacity.
• Tolerance: At its simplest, tolerance means the amount of exposure to potential negative change that you can endure without becoming deeply worried and upset. That's important because investors stand to make poor decisions when they're rattled by such feelings. Investor tolerance is often measured in the financial advisor's office via questionnaire-type assessments — i.e. what would you do if your stock lost 30% of its value in a market change?
• Capacity: There is also the amount of money you actually need to create with your investments so that you successfully meet the financial goals you've set for your post-career years. While tolerance is about how much risk you can psychologically bear, capacity is about how much risk you can and have to bear to get the job of retirement planning done. Capacity is typically determined by looking at ROI, how much time you've left before retiring, and at the income goal you've targeted for your retirement years.
Clearly, balance comes into play when it comes to tolerance and capacity. You have to acknowledge your ability to handle risk, but you also have to hit your marks by making profitable investments along the way to age 65 (or so). In the next section, we look at ways to think about striking that balance over time.
Time and Balance: Tolerance and Capacity
The timing of investment strategies can affect the relationship between tolerance and capacity. Consider the following examples.
• Early Planners: When you have three or four decades between your present investment scenario and your anticipated retirement age, your tolerance can typically stand to be more expansive. Even if you take a moderate loss early on, you've some time to recover. Point is, you're not so close to retirement that capacity is creating the same pressure that it will in coming years. However, if you find you're a low-tolerance investor, early on, it's important to set retirement goals accordingly. Your bond-heavy portfolio might not accommodate a vast retirement account in the way that risker stocks could help build.
• Mid-Career Portfolios: For planners whose working life has entered the middle phase, approaches to tolerance might change. That is, even if your tolerance is high — you like to shoot for high returns even if you take more significant losses along the way — the realities of your working income and expenses could mean that you have to switch tactics. A married mother of three with an average executive's salary and a freelancer artist for a partner might not be able to tolerate as much risk as, say, a single woman who got ahead with her well-timed startup's IPO. For the average and median retirement account, capacity and what it tends to dictate about sustainable losses may well mean maintaining a careful and steady process of building up less risky assets.
• Flush or Frugal? As you approach and enter retirement age, the relationship between capacity and assets will again largely determine how you create and maintain your fixed income. If you end your career a billionaire, congratulations. You almost certainly enjoy the risk capacity to absorb a loss of perhaps double-digit percentages when it comes to your in portfolio — you'd still have the liquidity to keep up car payments, a mortgage, and the like. However, if you're among the average/ median class of retirees, tolerance and capacity will likely play a more delicate role in your decisions. For example, when it comes to this type of retiree, experts at Schwab suggest a portfolio along the lines of 40% cash-and-bonds coupled with 60% stocks (their proposal is predicated upon a $1 million retirement account fueling $50,000 in annual income).
The point is to address the roles of these elements in your retirement planning, now. And remember, tolerance doesn't always conform to answers on a questionnaire. Be prepared to flex, if your portfolio hits a rocky point along the way. That 30% loss could suddenly seem more painful that it did when you filling out a form. In these cases, turn to your financial advisors and reconfigure your portfolio so that risk tolerance and risk capacity once again work for you in acceptable — and sustainable — ways.
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