Let’s look at a 24-year old who is earning fairly well, has no dependents, and lives with his parents. His father lost a lot of money in the stock market and, based on his family’s experience, he is wary of equity. So he makes sure that his investments are in fixed deposits, and Public Provident Fund, or PPF. His only venture into equity is via a balanced fund, which he believes is the safest option.
The young man has a low risk tolerance despite the fact that he has a high risk capacity. Risk tolerance broadly refers to an individual’s attitude towards taking risk. Risk capacity is his/her financial ability to actually do so. The latter will be based on the individual’s assets, income, liabilities, time horizon for the various goals, and number of dependents.
In the example that we have used, the individual is earning well, has no liabilities, no dependents, and since he is living with his family, has limited expenses. His investments in the stock market can go up and down and survive many cycles. It will not make much of a difference if he stays invested because he would need most of the money decades from now. He has a high risk capacity.
Unfortunately, he is letting his low risk tolerance--essentially, his comfort level with short-term volatility--dictate his long-term decision-making.
Understanding the deal
Risk tolerance is a term that comes up quite often when talking about portfolio planning. There are risk tolerance questionnaires which give some sort of indication of an investor's ability to withstand short-term losses. People are asked to imagine losses of certain magnitudes and see if that's something they have a comfort level with. So usually when you hear about risk tolerance, it's framed in terms of your psychic ability to handle a certain level of loss.
Too much focus on risk tolerance is that you're essentially letting your gut drive part of your decision making. Behavioral finance has shown with very valuable research how investors oftentimes undermine their own investment results by letting their gut or instinct do the driving.
By placing too much emphasis on your risk tolerance and how you feel about losses, particularly short-term losses that you may be able to recover from, one runs the risk of an overly conservative portfolio when saving for retirement.
Worth noting is that risk tolerance is not static. People overestimate their risk tolerances when the market is relatively good. And then they really pull in their horns when things go bad, and they might be inclined to dump everything and switch to a more conservative mix at what, in hindsight, could be an inopportune time.
This is where risk capacity really comes to bear. In a bad market, investors tend to let risk tolerance take the reins and cause them to sell when the market is maybe at a trough. This results in those paper losses turning into real losses.
Risk capacity is a much more important concept for people who are putting together their portfolios because it focuses on one’s actual ability to withstand losses in their portfolio.
Risk capacity is also a function of the time horizon. If you have a very short time horizon, your capacity for risk is obviously different than if you were talking decades.
So if you are someone with, say, only seven years until your desired retirement date, you literally cannot withstand losses of 35% in a total portfolio that consists entirely of equities at that point. You wouldn't be able to make that back before you need to start drawing upon your portfolio.
Risk tolerance and risk capacity are two very important concepts in the multifaceted topic of risk. Our suggestion is to let risk capacity lead the way. You might have to ride out some rough spots, but you should be able to get a portfolio that stacks the deck in your favour.
