Risk Tolerance vs. Risk Capacity: A Key Difference

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By Kevin Engbers, CFP®, Wealth Advisor

On the surface, the terms “risk tolerance” and “risk capacity” appear to be interchangeable. Yet, the difference between the two is crucial and best handled by an advisor who knows their craft well and understands the different shades of meaning. Although risk tolerance and capacity are concerned with risk, the difference will have real impact on how your financial plan comes together.

When you enroll in your company 401(k) or establish various investment accounts, you will likely be given a risk tolerance assessment. Completing a risk tolerance questionnaire is extremely important, but your financial advisor should be taking this process a step further. This isn’t just about how much risk you can stomach (tolerance), but the process should be informed by how much you can ultimately afford (capacity).

Through a series of subjective questions, risk tolerance questionnaires will provide you a score upon which to build an asset allocation for your portfolio. Yet these questions are sometimes answered with uncertain context of our lives and the market. When you take the questionnaire can affect your score – your answers could change if the market is in a steady upward climb or in free fall.

You also have to factor in if you are building wealth at this time in your life or living off your investments. I’ve been there, too, having added to portfolios when they are declining. That’s not always easy when your portfolio statement arrives and you find yourself wondering how you added $1,000 last month yet your account is down $2,000.

That might impact your tolerance for risk. If you are 26, you tough it out. But what if you are 62? If you’re approaching retirement, you need to guard the nest egg you have. In both situations, a financial plan, an advisor and a deeper understanding of risk tolerance vs. risk capacity can increase your financial confidence.

The Smiths and the Johnsons

For a case study, we use two couples – looking for help navigating retirement income planning. I’ll call them the Smiths and the Johnsons. Both families took a risk tolerance questionnaire, which showed they had identical risk tolerance scores. They each had a $1 million portfolio and said they could tolerate risk.

Working by the fiduciary standard and taking a holistic approach to their finances, we dug deeper into their incomes, expenses, life expectancy, and the impact of inflation. Our conclusion: While they may have the same tolerance for risk, their capacities for risks are very different. The Smiths discovered that to meet their retirement needs, they require $40,000 a year from their portfolio. The Johnsons recognized they only need to withdraw $20,000 per year. Both families show the same tolerance for risk but at very different capacities.

The industry often refers to a 4% withdrawal rule, so let’s look at what happens under this rule should there be a significant portfolio decline. The Smiths are unable to experience any decline under the 4% withdrawal rule without tapping their principal to meet their needs. The Johnsons, even with a 50% decline in their portfolio with a 4% withdrawal, will have the capacity to meet their $20,000 need.

Neither couple is very happy with portfolio declines, of course, but the Johnsons have more capacity in this case. Factoring in risk tolerance and capacity will help you and your advisor tailor your portfolio for your life situation – it isn’t one-size-fits-all.

The first step is to use a risk tolerance questionnaire, but the second step should incorporate the right advisor relationship. Your advisor will know you as a person and will understand your risk tolerance as informed by your risk capacity. The result will be a financial plan that’s right for you and your journey.

An Important Difference

Risk tolerance and risk capacity: When you understand the difference, you will appreciate why you’re working with one of our advisors. Our founding principle is simple: To help increase your financial confidence so you can confidently enjoy life. It really doesn’t have to be complicated.

We believe you should live your life by design, not default. If you’re looking for holistic, personalized advice that puts your interests first, then get in touch with us at Pinnacle and let’s get the process started.

Let’s talk!    

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