Risk Capacity Is More Than Just a Time Frame

When markets are doing well, investors are likely to underestimate risk and chase investments that are too aggressive for their risk profile. Amid the excitement, risk capacity—the ability to take on risk—can often be overlooked.

Advisors may struggle with evaluating an investor’s risk capacity because there are no standards or consensuses on how it should be assessed or integrated into the planning process. It is often treated qualitatively with anecdotes, which lack precision. Moreover, many in the industry have used the terms “time horizon” and “risk capacity” interchangeably, adding to the confusion.

Approaches to measuring risk capacity are often as basic as a few questions around time frame, downside limit, and savings behavior. For example, advisors may ask about your investment time frame, about how much of your investment you can afford to lose, and if you are able to save regularly. Advisors also use more sophisticated approaches such as comprehensive cash flow modeling. But even these only capture the investor’s current and potential outcomes, not the investor’s target goal—where the investor wants to be at the end of the time frame.

Time Frame Is Just the Starting Point

Of course, time frame has a material impact on risk capacity. Longer time frames can act to smooth out returns, mitigate volatility, and even out the effects of market cycles. However, a more rigorous, holistic, and meaningful risk-capacity assessment requires articulating and using a financial goal as the benchmark.

The answer to “How much risk you can afford to take?” can only be meaningfully answered by assessing the impact that risk has on achieving the goal. That is, can the investment strategy—and the investor—withstand the potential shocks (or sustained underperformance) without derailing the process of achieving their key financial goals? This means considering factors beyond time frame: Liquidity needs, wealth, composure, and ultimately robust modeling are needed to stress-test and evaluate capacity from a goal-shortfall perspective.

Imagine you are starting a road trip from San Francisco, but you are told only to head East and that you have seven days. Without a destination, how do you decide what speed to drive at? Can you afford to take the scenic route? How many stops can you take and for how long? You could drive 10 hours a day with two stops a day and make it to New York, but is this where you want to go? You may be more satisfied taking the scenic route, driving six hours a day, and reaching Chicago. To quote legendary baseball player Yogi Berra, “If you don’t know where you’re going, you might not get there.”

Goals Drive Meaningful Capacity Discussion

Without a goal, there is no context in which to assess risk capacity. Given a well-defined goal (in addition to a time frame), we can simulate and stress-test the financial plan to identify how it might evolve over time and across market conditions. Advisors can explore ranges of returns and see how likely different long-term outcomes are by using robust modeling tailored to the client’s timeline, cash flows, and strategy. This helps clients understand the impact of timing and cash flow needs, so they can set appropriate income range expectations. For example, a client may have flexibility over when they will need to start drawing down their assets. This pliability can be used to mitigate risk and can be used by clients to improve the chances of reaching their goals.

Advisors should also look beyond the simple probability-of-success number and contextualize it with how often and how deep the potential shortfalls are. For example, consider a case where there is an 80% chance of achieving the goal. That may sound encouraging at first blush, but it is worth considering how severe the shortfalls are in the unfortunate 20% of outcomes. An investor may be content if the average shortfall still funds the goal at 90%, but an average shortfall that only funds the goal at 40% could be cause for alarm. The magnitude and distribution of shortfalls to the goal are critical when considering risk capacity.

Wealth levels can also play a significant role if the investor buckets money for different goals with different investment profiles. For example, risk capacity may not be a major concern for a bucket that is only a small portion of the investor’s overall wealth, or “nice to have” (as opposed to a “need to have”) bucket, or a bucket where the timing of the goal is highly flexible.

Can Clients Keep Their Composure?

While risk capacity is largely a financial metric, advisors should also consider the psychological element of risk composure. Risk composure is the emotional reaction that people have when markets and portfolio values move up and down. The ability to stay the course when things are volatile can bolster their risk capacity. Risk composure is an element of risk tolerance, and there are benefits in drawing it out in risk capacity discussions with clients.

Advisors can best assess composure through observing past behaviors (if available) or from a risk tolerance assessment. One can ask how the client did or would have reacted during past market swings. But using modeling, rather than a questionnaire, has advantages: A model can illustrate potential stresses and test risk composure in (simulated) real time. How would the client react if their portfolio fell by 40%? That may depend on the effects on income ranges and cash flows. Dynamic modeling can assist with what-if scenarios by exploring the effects of adjusting timing, spending less and saving more, or having less ambitious goals. It can reveal where a potential strategy demands more risk capacity than a client may have.

Risk composure can be partly improved through education and behavioral coaching that encourage actions in the best interest of the client, such as not looking at their portfolio balances too often. However, it generally isn’t advisable for clients to have investment strategies beyond their risk capacity.

Having a time frame is a start, but framing clear goals and using robust modeling put shortfall risk at the center of risk capacity discussion. That allows clients to make informed trade-off decisions. Otherwise, they may be on a road trip to disappointment.