Risk: capacity vs tolerance

If you engage with a wealth manager or a financial adviser, their first steps will be to understand you and your wider financial situation and also to ask you about risk. There’s a good reason for it; this information helps them to determine your risk capacity and your risk tolerance which are both crucial to building a suitable long-term portfolio.

We get it, you want to get stuck in picking the investments you want to buy in your new account. But there’s a reason why professional advisors cover off the risk capacity and risk tolerance first - consistency and ‘staying invested’ are both crucial elements to achieving long term investing success. Understanding your risk capacity and tolerance will help to build a portfolio you’re comfortable with and that’s optimised for your goals. So let’s get stuck into it.

Risk capacity is quantitative

Risk capacity is quite simply, how much can you afford to lose?

Of course, nobody wants to lose money and we’re all investing with the hope of making gains, but not all portfolios are created equal. Investment markets all experience volatility to a certain degree, they rise and fall in line with what’s happening in the world and the global economy. Understanding your risk capacity will tell you how much risk you are capable of taking on, or how much you can afford to lose in a falling market.

You can work out your risk capacity by thinking about two things; wider wealth and time horizon. Let’s say that you’re investing £20,000 that you’ve just paid into your ISA. How does this £20,000 fit into your wider wealth? If it is all of your savings (apart from your ‘emergency fund’, we hope!) then you’re less likely to be able to afford to lose 20% or 30% if markets fall - you have a low capacity for loss here. Conversely, if that £20,000 in your ISA sits alongside several other investment accounts and you have plenty of savings, then you have a higher risk capacity. If the account did fall in value for a sustained period, it’s not going to change your entire financial picture.

Although you can’t just think about wider wealth; you also need to think about your time horizon when considering your risk capacity. Let’s again, say that you have £20,000 that you’ve just paid into your ISA and this makes up all of your savings. Previously, we agreed this meant you have a low risk capacity. But let’s also imagine that this £20,000 is being earmarked for your retirement in 20 years time. This long time horizon is going to increase your risk capacity. If markets fall tomorrow and your portfolio is down 20%, whilst it could be a worrying time, is this going to change your 20-year outlook or make you reconsider your investment goals?

Equally, using the example that £20,000 invested in your ISA is part of a much wider investment and financial plan, which we previously agreed meant you had a higher risk capacity. But what if that money is earmarked to help one of your children get onto the property ladder in 3-5 years time? Suddenly your risk capacity becomes much lower; if markets fall tomorrow and your portfolio is down 20%, do you have sufficient time to allow your portfolio to recover?

Risk tolerance is qualitative

You’ve spent some time considering your risk capacity. Great! You now need to think about your risk tolerance. Risk tolerance is a qualitative measure, it’s about emotion and comfort. You need to try to understand how you feel about taking investment risk.

If you have a high risk tolerance, you are very comfortable with volatility and with the prospect of investment losses. If you have a low risk tolerance, you are not very comfortable with volatility.

There is no right or wrong answer here but understanding your risk tolerance will help you to build a portfolio that you are comfortable with, and this is key for a long-term investment strategy. You don’t want to be moving in and out of markets like you’re doing the hokey cokey.

It’s not uncommon for an investor to think that they have a high risk tolerance when talking about the upside potential (i.e. a higher risk portfolio is likely to have higher long term forecasts - not guarantees - for returns). But then when you consider that the higher risk portfolio is also likely to lose more when markets are falling, that investor’s perceived risk tolerance comes crashing down. Investors are typically more risk tolerant when markets are rising and more risk averse when markets are falling. Unfortunately it’s impossible to build a portfolio that only goes up!

How do you feel about risk?

So how can you figure out your risk tolerance? Well, there are several things you can think about. Look back at your investments during previous periods of volatility and think about how you felt at that time. Think about Q1 2020 when the Covid-19 pandemic really kicked off, or perhaps go as far back as the Global Financial Crisis in 2008. How much did you lose at that time? Was your portfolio down 20%? 30%? How did you feel about it?

If you were anxiously chopping and changing your investments, selling out to cash or even just logging in every 10 minutes to check the latest valuation, chances are you have a lower risk tolerance or you might have been taking too much risk for your comfort levels. Conversely, if you were more relaxed about the losses, perhaps considering adding more to your accounts or repositioning your portfolio strategically (rather than in a panic), then you probably have a higher risk tolerance.

Another way to think about risk tolerance is to consider whether you want to take risk with this money. The answer to this question is not always a ‘yes’. Bearing in mind that everything carries risk (remaining in cash could be detrimental due to inflation just like investing could be detrimental due to capital losses), how much risk do you want to take with this capital? Use your answer to this question to inform your investment strategy. You don’t have to be all-in to equities or risk assets if you don’t want to.

Risk capacity and risk tolerance go hand in hand.

Now that you’ve considered both your risk capacity and your risk tolerance, you can use the two together to start to think about building your asset allocation and your portfolio.

Why do they go together? Think about it; you might have a high risk capacity (i.e. you can afford to withstand losses) but if you have a very low risk tolerance then you don’t want to take risk even if you can afford to do so. You might therefore build a more conservative portfolio.

Conversely, you might have a low risk capacity (i.e. significant losses would affect your investment goals) but you have a very high risk tolerance and you’re comfortable taking risks even outside of your capacity. If it means that you have to reconsider your plans in the future if you don’t meet your goals then so be it.

A great example here is if you’re saving to buy a property in 3-5 years time. You could argue that you don’t have a very high risk capacity as there is a fixed goal that you’re working towards. But, if you have a very high risk tolerance, you might decide to build a high-risk portfolio anyway and accept that if it means you have to push out your timeline to buy your property by another few years if markets fall in the intervening period then you’ll accept this.

To conclude, long term investment results come from being patient and being consistent. Whilst it might seem like an optional first step, getting your risk balance right is fundamental to building a portfolio that you are comfortable with. Comfort is good! It means you’re less likely to make rash or reactive decisions in the event that we experience volatile markets - which happens more than you think - and means you’re more likely to stay invested, stick to your plan and ultimately (hopefully!) reach your goals.

Date of publication: 3rd February 2023