How to work out your risk capacity

How do you work out your risk capacity, and why does it matter so much when you invest?

All investing involves risk, but each of us has a different capacity to take it on. Understanding yours is one of the most important steps in building a sound financial plan — and one of the key roles of a good financial adviser.

In this video, behavioural finance expert Greg Davies explains the difference between the risk you're willing to take and the risk you're able to take. He breaks down the three factors that shape your capacity for risk: your long-term risk tolerance, your financial risk capacity, and your emotional composure during market ups and downs.

You'll learn why your stage of life is central to how much risk you can afford: why a young person with strong earning potential can take on more risk, while a recent retiree drawing down assets should take on less. Greg also explains why risk capacity, not risk tolerance, is the more important factor for most investors, because the real constraint is the financial risk of running out of money.

The takeaway: if your risk capacity hasn't been properly assessed, speak to a financial adviser who knows how to do it. The older you are, the more important that becomes.

Chapters / Key points

• What risk capacity is and why every investor's is unique
• Risk you're willing to take vs. risk you're able to take
• The three factors: risk tolerance, risk capacity and emotional composure
• Why your stage of life determines how much risk you can afford
• Why risk capacity matters more than risk tolerance for most investors
• Why running out of money is the real constraint
• When and why to have your risk capacity assessed

Transcript

How to work out your risk capacity

RP: All investing involves a degree of risk, and every one of us has a unique capacity for risk. One of the key roles of a financial adviser is to work out, for each client, exactly what that capacity is. There are three main factors to consider.

GD: One is the risk that you are willing to take in the long term. How much am I willing to trade off risk in return for final outcomes? And then there's the risk that you are able to take, and there are two flavours of that. One is the risk that you are able to take financially, and that is risk capacity; and the other one is the risk that you're able to take emotionally, which is about your composure levels and your ability to withstand the ups and downs.

RP: How much risk you are able to take is largely dependent on the stage of life you are at. So, for example, a young person with good earning potential has a relatively high capacity for risk.

GD: So if someone is only investing a small portion of what we can think of as their total wealth, including human capital, then your capacity is high. If someone, however, if I put all my investable assets into the market and I have now just retired, and all I have ahead of me is no more income coming in, I've just got liabilities in the future. I've got spending to fund; this is a situation where my capacity is low. So risk capacity at its heart is simply put: am I investing a small or a very large part of my total wealth? And that tells me something about my financial ability to take risk with this pool of assets.

RP: Greg Davies says, in his view, there's been too much emphasis in the past on risk tolerance and not enough on our ability to take risk. A good adviser will get the balance right.

GD: Now if you're exceedingly wealthy, that isn't a problem because, typically, you have enough capacity to fund all your future expenditure without going broke; and so, for the really high end of the wealth market, risk capacity is a secondary consideration to risk tolerance. For most of the world's investors, the opposite is true. Risk capacity is actually the more important part of the puzzle. The risk you're able to take is far more important than the risk you're willing to take, because it is the financial fact that you might run out of money that is the constraining variable, not your ability to trade off risk and return emotionally in the long term.

RP: So, if you haven't had your risk capacity properly assessed, you should speak to a financial adviser who knows how to do it. The older you are, the more important that becomes.