Risk capacity and why you might accept investment risk
If you already have wealth and are investing to protect the future value of your assets, or if you are investing to create wealth it is not enough to identify and recognise your emotional acceptance of investment risk, what we call your risk tolerance. You also need to understand your risk capacity, this is the extent that you can afford to put capital at risk. Risk tolerance and risk capacity are not the same thing. Whilst you may have a high tolerance to risk for your “sleep at night” test, your actual financial capacity may not be supportive of the same risks. When investing, you need to consider, the capacity you have for a substantial loss of the capital you invested. A well-diversified portfolio is unlikely to see a total wipeout, but significant volatility (ups and downs of the market) can result in on-paper capital losses that are significant and under some circumstances may be realised. Risk capacity is, therefore, a very important consideration when investing and can be broken down into two core elements
- Your financial capacity to withstand a loss from the investment
- Your investment timeframe
Since 1920 there have been 44 instances of a market fall of 10% or more on the ASX. January 2020 was one of those times. Morningstar provides a summary of how we might react to these events. Noting the importance of recognising this difference between risk tolerance and risk capacity and potential reactions to loss aversion. Morningstar 5-minute read
Taking the discussion further, we consider the first question to ask when you invest is why?
Investing without purpose is a risk in itself. It is true for anything, if you don’t know why you’re doing it, it can be hard to judge if the risk-reward trade-off is suitable. When it comes to risk capacity, knowing why you’re investing is critical because your answer will also help you determine the second key question.
How much time do you have for the investment objective? Short-Medium-Long Term?
Having figured out what you’re investing for and how long your investment timeframe is, you can then consider what your financial capacity is versus the objectives.
Short-term. When saving for a short-term goal, perhaps a holiday. Your risk capacity is low because if for example you invested in shares and there is a dip in the value just before your planned trip, you’re not going to have the funds to go. So, time becomes the key driver for risk capacity in this case.
Medium-term. There are many reasons to invest, we’ll use education savings as an example. If you’re saving for school fees that won’t start for 5+ years, for example, you may have a higher risk capacity. Those same shares you invested in for the holiday, would have time to recover (assuming they are a good investment). Fluctuations even in the best quality companies around the world is part of the reality of investing, so having sufficient time to benefit from the investment is an important consideration.
By investing for longer, you may feel like your risk tolerance is greater and in one sense, time does afford you some degree of protection. However, it is still important to consider if you can afford capital loss from the investment. So as soon as you dial up the risk in the type of assets you are investing in, your capacity for real financial loss as well as time becomes a greater factor.
Long-term. As superannuation is by nature a very long-term investment possibly 60+ years, we’ll use this as an example. When you are younger your capacity to ride out the ups and downs of financial markets is greater than when you are approaching retirement or already retired. This would be an obvious assertion. However, there are other considerations for your risk capacity, such as having other safety nets in place, for some this could be a defined benefit pension, or perhaps an investment property, or other investments outside super, that could increase, or decrease your risk capacity when it comes to super. The nearer to retirement, the more critical the risk capacity discussion? Not necessarily so, being too conservative in your younger years may result in a very large capital shortfall when the time comes to retire.
We encourage you to seek professional financial advice to discuss your needs in detail. Your financial capacity to withstand a loss from an investment is going to change, depending on your financial position, your goals and objectives and importantly, the time frame of the investment.
We are here to help. We have an experienced, qualified, professional adviser.
General Advice Warning: The information in this communication is provided for information purposes and is of a general nature only. It is not intended to be and does not constitute financial advice or any other advice. Further, the information is not based on your personal objectives, financial situation or needs. You are encouraged to consult a financial planner before making any decision as to how appropriate this information is to your objectives, financial situation and needs. Also, before making a decision, you should consider the relevant Product Disclosure Statement available from your financial planner.
