Risk Capacity vs. Risk Tolerance

[iim7V7IM7]

As an “accumulation” investor we frequently talk about setting an asset allocation based on “risk tolerance” (e.g. your ability, willingness and need to take risk to determine your equity to fixed income asset allocation).

During retirement, as a “distribution” investor doesn’t “risk tolerance” really shift to “risk capacity” (e.g., the amount of risk that one can responsibly take without jeopardizing their financial objectives) when your work capital diminishes to deriving income from one’s portfolio?

For example, if I look at our retirement plan, I see different income objectives, with different priorities and time horizons.

LONGEVITY Goals
We have money that is needed in < 5 years to buy a SPIA and to fund a Social Security Bridge until I reach age 70 to fund “essential” expenses. This is invested in a money market, CDs and MYGAs. We also have money that is needed 15 years in the future to buy another SPIA around age 80 to fund “essential” expenses and that money is a 40/60 equity/fixedincome portfolio.

LIFESTYLE & LEGACY Goals
We have money needed to fund “discretionary” expenses for years 1-6 invested in a money market, CDs and MYGAs. For years 7-10, this is invested in a 30/70 equity/fixed income portfolio. We have money needed to fund “discretionary” expenses for years beyond year 10. This is invested in a 60/40 equity/fixed income portfolio.

LIQUIDITY Goals
We have money that may be needed as a buffer for large, irregular, unplanned out of pocket expenses across the remainder of our lives. This is invested in a 30/70 equity/fixed income portfolio. We also have home equity and LTCI in this category.

While I suppose this is very much akin “time-segmentation” thinking in terms of creating “buckets”, it allows me to clearly visualize risk decisions based on “risk capacity” based on the importance of the income objective and time horizon. If this was one large 47/53 equity/fixed income portfolio I could not as easily see how we were doing with respect to each goal. I am sure that for some this may seem overly complicated.

I also feel this approach minimizes the likelihood of underspending on discretionary expenses vs a composite SWR when we are younger. We can front load our discretionary spending across the first decade (aka Go-Go) and throttle down in Slow-Go period. Knowing that our essential expenses are covered with reliable income and that we have a liquidity buffer gives us more confidence to spend on discretionary pleasures.

Food for thought

[jebmke]

isn't risk capacity the same as ability? That has been how I think of it. Tolerance ~= willingness.

As I planned retirement, I had high capacity, low need. I decided to de-risk to avoid behavioral effects of high risk.

[dbr]

isn't risk capacity the same as ability? That has been how I think of it. Tolerance ~= willingness.

As I planned retirement, I had high capacity, low need. I decided to de-risk to avoid behavioral effects of high risk.

I agree. The concept of capacity is supposed to be captured by ability and the concept of tolerance, which is psychological, is supposed to be captured by willingness. I would also comment that need is supposed to capture wants and objectives not raw need. I think the language, which I think comes from Swedroe, is not the choice of words I would use, but once a person considers what is really involved I think it takes care of itself.

[WoodSpinner]

OP,

I also structure my Portfolio by positioning various assets based on my Retirement Plan and Goals.

You might find this post in a Bottoms-Up Portfolio structure of some interest….

viewtopic.php?t=392120

[Fallible]

As an “accumulation” investor we frequently talk about setting an asset allocation based on “risk tolerance” (e.g. your ability, willingness and need to take risk to determine your equity to fixed income asset allocation).

During retirement, as a “distribution” investor doesn’t “risk tolerance” really shift to “risk capacity” (e.g., the amount of risk that one can responsibly take without jeopardizing their financial objectives) when your work capital diminishes to deriving income from one’s portfolio?
...

Good explanations and definitions on the difference between risk tolerance and risk capacity are in "Investopedia" and the wiki's "Asset allocation" and "Risk tolerance" pages that include Larry Swedroe's series on "Ability, Willingness, and Need to take risk."

Investopedia:

While risk tolerance refers to an individual's psychological willingness to take on risk, risk capacity relates more to the financial ability to endure potential losses.

Among its takeaways:

Risk tolerance is about emotional & psychological comfort with risk; risk capacity is about one's financial ability to bear it.

Both factors are crucial for crafting a balanced, effective investment strategy.

Risk tolerance is fluid and can change due to life events, age, and economic conditions.

Risk capacity is determined by concrete financial circumstances like income, debt, and time horizon.

https://www.investopedia.com/ask/answer ... pacity.asp

[RationalWalk]

This:

- Risk tolerance is about emotional & psychological comfort with risk
- Risk capacity is about one's financial ability to bear it.

Both factors are crucial for crafting a balanced, effective investment strategy.
Risk tolerance is fluid and can change due to life events, age, and economic conditions.
Risk capacity is determined by concrete financial circumstances like income, debt, and time horizon.
Achieving harmony between risk tolerance and capacity is key for financial peace of mind.

https://www.investopedia.com/ask/answer ... pacity.asp

In the accumulation phase, because of the long investment time horizon and human capital, one typically has a high capacity for financial risk and the level of risk they are willing to assume rests more heavily on risk tolerance. In the decumulation phase, one typically has a declining capacity for investment risk because of the shorter time horizon and diminished human capital. Risk tolerance should play a less significant role.

Risk capacity should be the driving factor during both accumulation and decumulation, but that requires a level of cold rationality that humans don't typically possess. The emotional side of investing (tolerance) is often, even usually, in the driver's seat.

[RationalWalk]

The other part of it is the changing nature of "risk" in the accumulation vs. decumulation phases. One of the principal dimensions of risk involves inflation risk -- loss of purchasing power of one's financial assets. Generally, during accumulation with high human capital, and lower relative financial capital, one's inflation risk is lower. We expect that our earnings will increase over time with inflation, and consequently we can minimize inflation-hedging financial investments that typically have lower returns. During decumulation, inflation is one of the greatest risks since we are depending primarily on our financial capital; consequently we should typically emphasize inflation-hedging financial investments and avoid investments exposed to inflation risk. Dr. Bernstein has advised and personally emphasizes short-term bonds, TIPs, and I-Bonds in amounts sufficient to cover one's income needs in retirement. He also advises "If you've won the game, stop playing" which is a suggestion based on the idea that one's capacity for risk is lower in retirement and that risk should be minimized to the degree possible afforded by the amount of your accumulated financial capital.

[Northern Flicker]

With respect to risk capacity, risk tolerance, and the need to take risk, all three are important considerations during both accumulation and retirement.

[Kevin M]

isn't risk capacity the same as ability? That has been how I think of it. Tolerance ~= willingness.

As I planned retirement, I had high capacity, low need. I decided to de-risk to avoid behavioral effects of high risk.

I agree. The concept of capacity is supposed to be captured by ability and the concept of tolerance, which is psychological, is supposed to be captured by willingness. I would also comment that need is supposed to capture wants and objectives not raw need. I think the language, which I think comes from Swedroe, is not the choice of words I would use, but once a person considers what is really involved I think it takes care of itself.

Correct.

Ability is what OP is calling capacity.

Willingness is the emotional component; i.e., how likely are you to abandon your plan when stocks drop 50% or more?

Need is about how much growth is required to meet objectives, with the understanding that higher risk = higher expected return.

[rule of law guy]

interesting original post.

as retirees with enough financial resources, we balance our principal objective (safety with adequate return) with an ability and some willingness to bear risk. risk would provide enhanced returns (hopefully) primarily for our heirs, a secondary objective.

it's a nice problem to have, balancing safety and opportunity, and I suppose you better have the capacity to bear risk if you have an objective to seek outsized returns

[iim7V7IM7]

Thanks for the comments and discussion.

I agree that the ability to take risk is similar to risk capacity.

Ability considers horizon, stability of income, the need for liquidity and whether or not there is a backup if you are wrong. I just think that risk capacity is a term that becomes more relevant when an accumulation portfolio changes to a distribution portfolio mindset.

Classic bucketing (time segmentation) is mostly discussed for its psychological benefits to investors to help them stay the course. Whereas one’s risk capacity considers the current balance, investment horizon, goal, volatility of the investment and its criticality to your finances. This asset positioning links asset allocation to spending decisions based on timing.

For myself, I take comfort in being able to visualize specific investment against specific longevity, lifestyle, liquidity and legacy goals. They all have different spending criticality and time horizons. It is a bit of a bottoms up approach.

By having a clear understanding of our essential expense income, buffer assets for liquidity it frees up concerns about running out of money (longevity) and provides line of sight when you are younger for the older, potentially less capable you or your spouse. It provides clarity to just how much you have to fund your discretionary spending (and legacy) in retirement. If you want to spend more earlier in retirement (go-go years) and less later on (slow-go years) it provides clarity on that.

[Florida Orange]

If you think of the risk to your overall financial situation, rather than the riskiness of a particular, discreet investment, I don't think anybody ever takes any more risk than they have to. This includes the risk of not taking enough risk. For example, cash is generally thought of as riskless but it doesn't keep up with inflation so it's not really riskless. Not losing money, nominal or real, is the most important thing to almost everybody. I know people will say a portfolio that is 100% stocks is risky, but no rational person would take that risk unless they could afford to, so for that person it's not really risky.
In other words, nobody really has any risk tolerance, only the ability to take risk on an investment the undesirable outcome of which would not significantly jeopardize their financial well being.

[RationalWalk]

Risk is what's left when you think you've thought of everything. It cannot be eliminated. All you can do is address certain risks that you know about, and hope for the best.

[nisiprius]

...For example, cash is generally thought of as riskless but it doesn't keep up with inflation so it's not really riskless...

People advocating risky assets commonly mix up two different meanings of the word "cash."

"Cash" can mean physical currency, a fixed number of dollars. That does not keep up with inflation. Neither does a non-interest-bearing bank account.

But the word "cash" is often used to refer to interest-bearing bank accounts, money market mutual funds, and Treasury bills. Historically, all of these have in fact kept up with inflation.

Obviously you do need to shop for the better bank deposit rates. And both bank accounts and Treasury bills suffered from periods of time when their interest rates were artificially capped by government policy. Of course, the risk of the government doing that is legitimately part of the risk of these kinds of assets, so it should "count," but it's worth knowing.

The easiest data to find is for Treasury bills. PortfolioVisualizer actually uses the word "cash" for Treasury bills, and over PortfolioVisualizer's full data range they have beaten inflation:

Source


I don't want to hide the 1940s. From 1926 through 5/31/2023, the inflation-adjusted growth of $10,000 invested in Treasury bills, using the SBBI "Bills" series, has been:



The final balance was $13,162, and the average annual real (inflation-adjusted) return has been 0.28%. The nominal (number of dollars) return has been 3.28%.

[Florida Orange]

People advocating risky assets commonly mix up two different meanings of the word "cash."

"Cash" can mean physical currency, a fixed number of dollars. That does not keep up with inflation. Neither does a non-interest-bearing bank account.

But the word "cash" is often used to refer to interest-bearing bank accounts, money market mutual funds, and Treasury bills. Historically, all of these have in fact kept up with inflation.

Thank you. That's interesting information and you make a good point. I was trying to say that risk tolerance would be better described as volatility tolerance because reasonable, prudent investors always seek to minimize the risk to their portfolios and their financial survivability. In the investing world, I doubt true risk tolerance exists.

[dbr]

People advocating risky assets commonly mix up two different meanings of the word "cash."

"Cash" can mean physical currency, a fixed number of dollars. That does not keep up with inflation. Neither does a non-interest-bearing bank account.

But the word "cash" is often used to refer to interest-bearing bank accounts, money market mutual funds, and Treasury bills. Historically, all of these have in fact kept up with inflation.

Thank you. That's interesting information and you make a good point. I was trying to say that risk tolerance would be better described as volatility tolerance because reasonable, prudent investors always seek to minimize the risk to their portfolios and their financial survivability. In the investing world, I doubt true risk tolerance exists.

In the context of setting an asset allocation it is implied that risk means volatility, hence demonstrations such as "can you tolerate a loss of 50% of your portfolio value" and so on. People are eager to supply all sorts of perfectly reasonable considerations of what is risky, but that is beside the point for the context of the discussion as usually presented. An example of a perfectly good but entirely different risk concern would be withdrawal rate analysis of whether or not a portfolio would run out of money during retirement. In that case the dependence on asset allocation is quite different from what is involved in considering volatility. An all bond portfolio is the most risky and an all stock portfolio is not particularly risky.

[Florida Orange]

In the context of setting an asset allocation it is implied that risk means volatility, hence demonstrations such as "can you tolerate a loss of 50% of your portfolio value" and so on. People are eager to supply all sorts of perfectly reasonable considerations of what is risky, but that is beside the point for the context of the discussion as usually presented. An example of a perfectly good but entirely different risk concern would be withdrawal rate analysis of whether or not a portfolio would run out of money during retirement. In that case the dependence on asset allocation is quite different from what is involved in considering volatility. An all bond portfolio is the most risky and an all stock portfolio is not particularly risky.

That's the difference between volatility and risk. An investment where you could quickly double your money or lose your entire investment is highly volatile, but if you invest a very small amount of money it's not very risky. But if you bet your entire financial future on an investment where there is a small but non-negligible chance that you could get wiped out, it's risky even though it may not be very volatile. Most investors have almost no risk tolerance although some of them can withstand quite a bit of volatility.

[RationalWalk]

There's a difference between income volatility and asset price volatility.

[dbr]

In the context of setting an asset allocation it is implied that risk means volatility, hence demonstrations such as "can you tolerate a loss of 50% of your portfolio value" and so on. People are eager to supply all sorts of perfectly reasonable considerations of what is risky, but that is beside the point for the context of the discussion as usually presented. An example of a perfectly good but entirely different risk concern would be withdrawal rate analysis of whether or not a portfolio would run out of money during retirement. In that case the dependence on asset allocation is quite different from what is involved in considering volatility. An all bond portfolio is the most risky and an all stock portfolio is not particularly risky.

That's the difference between volatility and risk. An investment where you could quickly double your money or lose your entire investment is highly volatile, but if you invest a very small amount of money it's not very risky. But if you bet your entire financial future on an investment where there is a small but non-negligible chance that you could get wiped out, it's risky even though it may not be very volatile. Most investors have almost no risk tolerance although some of them can withstand quite a bit of volatility.

"X

I think it is most helpful in terms of language to suggest that risk should be phrased as "risk of X" where "X" has to be specified so we know what we are talking about. "Risk of volatility" is certainly legitimate and so are all kinds of other risks an investor might be concerned about. For better or for worse in portfolio theory risk means exactly just volatility. And, of course, your example where the volatility is really a small standard deviation of annual returns but a tail that extends to a real possibility of a return of -100%, aka wiped out, is certainly something a person should consider.

[260chrisb]

interesting original post.

as retirees with enough financial resources, we balance our principal objective (safety with adequate return) with an ability and some willingness to bear risk. risk would provide enhanced returns (hopefully) primarily for our heirs, a secondary objective.

it's a nice problem to have, balancing safety and opportunity, and I suppose you better have the capacity to bear risk if you have an objective to seek outsized returns

I like "balancing safety and opportunity"! Well said. I didn't have a good catch phrase for it until now but started that approach in late '19 as I was two years away from retirement and will continue that approach for the foreseeable future.

[jebmke]

There's a difference between income volatility and asset price volatility.

Unless you have little or no income - often the case in ER where one is drawing down assets.

[dbr]

There's a difference between income volatility and asset price volatility.

Sure. You can ask what is the "risk of X" where X is income being unreliable or where X is the price is variable in time. Conventionally in portfolio theory risk is used to refer to the variability of return, so risk of X is risk of having a large standard deviation of periodic return.

[iim7V7IM7]

I guess that I just prefer to position our assets in such a way that spending needs and their priority/criticality are aligned with investment decisions. This suggests to us to use an array of:

- investments (money markets, CDs, Treasury Bonds, Bond Mutual Funds, Equity Mutual Funds) and
- insurance products (MYGAs and SPIAs).

Some spending needs require significant cash at the beginning of our retirement (0-5 years) so those are positioned with less risky investments. The longer term needs that are subject more to inflation risk are invested in sub-portfolios ranging from 30/70 to 60/40 depending on the horizon to when withdrawals need to begin and how long they need to sustain.

As a composite, the stocks and bond funds comprise about 45% of our nest egg, longevity insurance products (SPIAs) about 30% and about 25% in a mix of cash, CDs, Treasury Bonds and short-term insurance products (MYGAs). The stock and bond portion is about 50/50 as an aggregate mix, but it is easier for me to see it as three discrete portfolios funding three discrete spending needs with differing priorities and time horizons.