"No risk, no reward." You've probably heard this phrase before. Fundamentally, you understand that to achieve a higher return on your investments, you need to be more aggressive. That doesn't always mean you're willing to be more aggressive.
This may be because those helping you with your investments (could be a financial advisor, sometimes a family member or friend) are approaching things the old way. It probably started with a risk tolerance survey.
In other words:
How will you feel if the market drops 25% tomorrow?
What do you think you if the market is down longer than a year?
Will you sell your investments, hold, or buy more if the market does XX?
Here's the problem with that approach: it's hard to predict how we'll actually feel in a situation that hasn't happened yet. As Mike Tyson said, "Everyone has a plan until they get punched in the mouth."
Wealth advisors like me will often offer financial planning as a service to help you with more than just your investment portfolio. Helping you grow your investments is important, but taking that a step further, it's important that we planners help you achieve your goals, not just a rate of return. That's why we'll show you with facts, data, and science how much risk your situation can afford to bear.
Financial risks are better managed when they're first measured, not predicted. Then, after you're able to measure your capacity for risk, you can learn to manage your emotions around it. Let's examine the differences between risk tolerance and risk capacity.
What's the Difference Between Risk Tolerance and Risk Capacity?
Risk tolerance has more to do with your feelings. It answers the question "how willing are you to face investment losses?"
Risk capacity is more empirical and measured. It answers the question "how much financial loss can your situation endure?"
Whereas risk tolerance deals with your personality and your emotions, risk capacity is concerned more with the calculating the chances of investment success and failure to achieve a goal in a certain timeline.
How Are Risk Tolerance and Risk Capacity Measured?
If you've ever worked with a financial advisor, you may have completed a risk tolerance questionnaire. Essentially, you'll get about 10 questions asking how you'd feel if certain things happened with your investments. After you complete the test, you receive a score, and then your advisor puts you into a portfolio that matches your risk score. The problem with this approach is that it's hard to measure how you'll actually feel, rather than how you think you'll feel.
When measuring risk capacity, you'll take into account important financial data. How much money do you have? Do you have a sizable income? Is your income volatile or stable? Do you have enough insurance? How much debt do you have relative to your assets and income? Do you need money for certain large value goals, or are your goals 10+ years away? All of these questions are more factual than they are psychological, and investments using this approach are designed to match the best case scenario with each question's answer.
How I Help My Clients with Risk in Their Investment Portfolios
I find it a better approach to start with risk capacity when selecting the right investments for a portfolio. I believe your investments should match your overall financial plan. When investments are structured to serve a bigger purpose, and you the investor understand how they fit into the big picture, then short term losses become easier to stomach.
If you're saving for your children's education, which do you prefer:
Preventing a 20% decline in your kids' 529 plans?
Funding your kids' education in its entirety?
Assuming you choose option two, you now understand that investing is less about the return and more about the probability of success for a given goal.
Understanding that we start with risk capacity, your emotions are still important. As any worthwhile financial advisor would suggest, remaining invested for the long haul is the best chance of long-term success. However, if I feel like you're going to panic and sell all your investments and return the money to your bank account, we may need to factor in your risk tolerance. In many situations, it's better to stay invested partially in the market rather than having nothing in the market.
In a nutshell, I'll analyze a client's risk capacity and coach their risk tolerance.
Case Study: Risk Capacity
Case Study 1: The Restaurant
Jake was a former professional athlete, and he was a good steward of his money during his career. Now retired from sports, his entrepreneurial itch compels him to open a restaurant. He has $50,000,000 to his name, and he estimates that he'll need upfront capital of $5,000,000. That means if the whole venture is a complete flop and he doesn't recover any of his money, he's got $45,000,000 that he could consider a different (maybe more calculated) investment opportunity.
Thomas is leaving his role in sales to begin a restaurant as well. His total net worth is about $1,500,000. Assuming this venture costs the same $5,000,000 that Jake's did, he's going to need to borrow some money. In this case, if Thomas fails at the restaurant business, he's probably draining some of his personal net worth, and he'll also have to worry about a loan to repay.
Here's the interesting part: Jake and Thomas both have the same amount of money going into the restaurant, so theoretically, they have the same mathematical chance to make this business work. However, it's quite obvious that Thomas stands to lose much more than Jake if the business fails. This means that Jake has a much greater capacity for risk than Thomas, even though they may have the same comfort for risk.
Case Study 2: Retiring
Susan is 60 years old and wants to retire in 5 years. She has much of her retirement savings in a 401(k) and an IRA, with a little bit in a taxable brokerage account. She doesn't have any long-term care insurance, and she has a history of longevity in her family. She begins to consider changing her investment strategy as she nears retirement.
Julie is 45 years old and still considers retirement to be more than two decades away. She still understands the importance of saving for retirement, and she wants to optimize her investment portfolio to plan for the future.
By viewing this objectively and measuring risk capacity, it's obvious that Julie has more capacity for risk. First, Susan is 5 years from retirement. If she hits a bad market early in retirement, she may draw down too much of her money too quickly and jeopardize her later years (otherwise known as sequence of returns risk). Julie has time to see a lot of market upswings and downswings, so she can afford to be more aggressive. In addition, because Susan doesn't have long-term care insurance, having her assets exposed to market losses at the same time that her health care costs go up could also put her at risk of spending down her money.
Summary
An individual might have more capacity for risk than he or she can tolerate, and vice versa. Susan may be want to be aggressive and earn a lot in the 5 years leading up to retirement, but that doesn't mean that her big picture financial plans can afford the downside. Jake may be scared to death to put his money into something aggressive, but he clearly has the capacity to take risks.
These examples show the importance of having quality financial advice on your side. If you're uncomfortable with risk but your financial plans could benefit from strong growth, then a financial advisor can help you manage your emotions. If you're comfortable taking on risk, but too much risk would jeopardize your financial success, then an advisor could bring this information to light.
Final Thoughts on Investment Risks
Your investment portfolio is more than just a place to stuff money and watch it grow. I believe that money is a tool to fuel dreams and passions, but we have to be good stewards of the resources provided to us. Part of being that good steward is understanding how to balance risks with our money to give us the best opportunity for growth.
How to Get in Touch
Do you have questions about what you just read?
Do you want to start a conversation with an advisor but don't want to be pitched before you get to know him/her?
Hi, I'm Tyler Shamblin.
I'm a CFP® professional who helps busy people make work optional as fast as possible, while still enjoying their life today.
I understand that asking for help with money can be a bit of a leap, and the last thing you want is to feel like you're a project.
In a conversation with my firm and me, we'll move as fast or slow as you feel comfortable, giving you freedom to decide if we take any next step or if we part ways.
You can contact me using this information below:
Office: 901-752-0022
Cell: 901-482-6998
If you'd like a second opinion on your financial situation, don't wait to reach out. Schedule a time to visit us at our Germantown office, or you can schedule a virtual web meeting. Either way, we look forward to connecting with you!
Century Financial is a wealth management firm located in Germantown, Tennessee. Our financial advisors have about three decades of combined experience in asset management, financial planning, and other related services for clients in the Memphis area and beyond. Learn how you can grow and preserve your wealth with guidance from our team.
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