Understanding Your Risk Capacity
Concannon, CFA, CFP@
Chief Investment Officer
"Risk capacity measures how much risk you can accept without jeopardizing your investment goals"
We all face risks as investors. Stock market volatility, interest rate changes, and permanent loss of capital are just a few of the many risks we confront in pursuit of satisfactory investment returns. And avoiding investment risk, unfortunately, only exposes us to yet another risk—the risk of not earning sufficient returns to meet our needs.
But how much risk is appropriate? The answer is different for every investor and depends in part on your risk tolerance and your risk capacity. Risk tolerance is about emotions. How do you emotionally respond to seeing your investments decline in value due to a drop in the market? Does it cause you to lose sleep? Does it make you want to sell your investments for fear of further declines? Or do you view it as an opportunity to improve your returns by investing more while prices are lower? Your answers to these questions tell us a lot about your risk tolerance. Risk capacity, on the other hand, can be measured objectively. It is a mathematical measure of how much risk you can take on without potential losses causing irreparable harm to meeting your investment goals.
Risk capacity is determined primarily by three factors: 1) time horizon, 2) the size of your investment portfolio relative to future additions and withdrawals, and 3) the amount and reliability of income from sources other than your investment portfolio. A simple example will help to explain how these factors affect risk capacity. Assume that a couple has saved $50,000 for the required down payment on a house they plan to buy in one month. Because their time horizon is short, one month, and the future withdraw is large, 100% of the amount saved, this couple has zero risk capacity. But if that same couple had $100,000, was able to save additional money from other income sources, and the house purchase was five years away, they would have the capacity to accept some investment risk in order to earn a higher return.
Determining your risk capacity for one-time purchases like this is fairly simple. But what about determining your risk capacity for retirement monies accumulated over the course of your career? The three factors remain the same. However, as time passes changes to each factor will cause your risk capacity to change as well.
It is common advice that you can accept higher levels of investment risk when you are young and lower levels as you grow older. This is generally true, but why? The answer is found within the factors that determine risk capacity.
Let’s take a look at how a hypothetical investor’s risk capacity might change over the course of her accumulation years—ages 25 to 65. Our investor begins with a small investment portfolio and contributes to it annually at a rate equal to 10% of her salary for the first 20 years and 15% for the next 20 years. Her employer contributes an additional 3% of her salary.
Our investor receives annual salary increases with larger increases periodically for promotions. We assume a 6% annual return on her investment portfolio throughout. Basically, our investor is somewhat typical, but perhaps more disciplined than many.
The risk capacity factors for our investor are as follows: 1) Her time horizon is initially very long at 40 years, but of course becomes shorter as time passes. 2) The cumulative value of all future additions is initially much larger than the investment portfolio, but becomes smaller over time while the portfolio itself grows. 3) She has a steady and growing source of outside income in the form of a salary.
To determine our investor’s risk capacity, we compare the cumulative value of all future additions to the value of her portfolio. Think of these as two separate buckets. The portfolio bucket is currently exposed to investment risks while the future-additions bucket is not. The larger the size of the future-additions bucket relative to portfolio bucket, the more it can offset losses incurred in the portfolio bucket. Our investor’s risk capacity is highest at the start of her career because that is the point at which the cumulative value of all her future additions is largest relative to her portfolio’s value. As time passes, the total amount of additions remaining to be made decreases, and the portfolio’s value grows. This lowers our investor’s ability to make up for investment losses through additions to the portfolio, thereby causing her risk capacity to decrease.
We can visualize this change in risk capacity by plotting on a graph the difference between the cumulative present value of future additions and the investment portfolio’s value for each year of the accumulation period. As shown in Figure 1, our investor’s risk capacity begins at a high level and stays nearly flat from ages 25 to 40. After age 40, her risk capacity declines at an increasing rate, reaching its lowest point at retirement age. That is the point that our hypothetical investor will stop making additions to her investment portfolio and begin taking withdrawals.
We can test our results by comparing the rates by which portfolio additions would need to increase to recover from a one-time 20% permanent loss to our investor’s portfolio at age 30 versus age 60. Based on the assumptions used in our example, by age 65 our investor could make up for a 20% permanent loss incurred at age 30 by increasing her annual savings rate just 0.6 percentage points. A 20% loss incurred at age 60, however, would require her to increase her annual savings rate by 25 percentage points over the final five years of her career—an unlikely possibility. Therefore, it would be prudent for our investor to lower her risk exposure as she approaches retirement age to reduce the chance of large losses.
Life, of course, is a lot messier than our example. Your own accumulation years will likely be different from our hypothetical investor’s. But the factors that determine your risk capacity are the same, and therefore your risk capacity over your accumulation years will likely follow a similar pattern.
Next quarter we will calculate how risk capacity changes during your retirement years. The results may surprise you.
Footnotes: Our hypothetical investor begins with a $25,000 investment portfolio and a $45,000 salary. Salary growth equals 5% annually from ages 25 to 39, and 3% annually from ages 41 to 65, with a 20% increase every fifth year. The cumulative value of all future additions is measured using the present value calculated at a 3% discount rate.