When it comes to retirement planning, one of the most important yet often misunderstood topics is the distinction between risk tolerance and risk capacity. These two concepts are critical for shaping an effective investment strategy that aligns with both your comfort level and your financial reality. Many people mistakenly rely solely on their emotions when assessing risk, potentially overlooking what their financial situation truly demands. In this blog post, we’ll explore the differences between risk tolerance and risk capacity, why they matter, and how understanding both can lead to a more balanced and successful retirement plan.
What is Risk Tolerance?
Risk tolerance refers to the emotional side of investing. It’s essentially how much market volatility you can handle without losing sleep at night. When your portfolio takes a 10% dip in one week, how do you react? Some people are able to shrug it off, trusting that markets will eventually rebound, while others may feel a sense of panic, tempted to sell off investments and move to safer assets.
Risk tolerance is deeply personal and varies from one individual to another. It’s shaped by past experiences, personality, and emotional resilience. For example, someone who experienced a significant market downturn early in their investing journey may be more risk-averse, while another person who saw long-term gains over decades might be more comfortable with short-term losses.
However, while risk tolerance is important, it’s only part of the equation.
What is Risk Capacity?
Risk capacity, on the other hand, is a rational, numbers-driven concept. It refers to how much risk you can afford to take based on your financial situation, goals, and time horizon. Unlike risk tolerance, which is influenced by emotions, risk capacity is grounded in facts. It looks at your income, savings, investment timeline, and overall financial health to determine how much risk you need to take to reach your retirement goals.
For example, a 30-year-old with decades before retirement and a steady income may have a higher risk capacity than someone nearing retirement in just a few years. But sometimes, your risk capacity can be higher than your emotional comfort with risk—a gap that can be critical to understand.
Example 1: Bob’s Low Risk Tolerance, High Risk Capacity
Let’s meet Bob. Bob is 55 years old, with a stable job and plans to retire at 65. When he first sat down with a financial advisor, he expressed a very low risk tolerance, wanting to keep most of his investments in safe, low-yield options like bonds and cash.
But here’s the issue: when they crunched the numbers, it became clear that with his current savings rate and conservative investment strategy, Bob was on track to fall short of his retirement goals by a significant margin. Even though Bob was emotionally uncomfortable with taking on more risk, his financial situation—steady income, 10 years before retirement, and the ability to weather short-term market fluctuations—meant he had a much higher risk capacity than he realized.
By aligning Bob’s strategy with his risk capacity rather than just his risk tolerance, his advisor was able to suggest a more balanced portfolio, giving him a better chance at reaching his retirement goals while still managing his emotional comfort.
Example 2: Linda’s Overlooked Risk Capacity
Next, let’s look at Linda. At 60, Linda is planning to retire at 65. Like Bob, she preferred low-risk investments and was cautious about market dips. But when they evaluated her financial situation, they found she had been a disciplined saver, had no debt, and was on track to retire with over a million dollars. She also had a pension and Social Security that would cover 60% of her expenses in retirement.
Although Linda was naturally risk-averse, her risk capacity suggested she could afford to take on more risk for long-term growth. With retirement being a 20- to 30-year journey, it was crucial for Linda to ensure her investments continued growing, not just during the five years before retirement but throughout her retirement as well. Her financial advisor recommended a more balanced portfolio that would help her money last for decades.
Time Horizon: A Critical Factor in Risk Management
One of the most important elements in understanding risk capacity is your time horizon. Your time horizon refers to how long you have until you need your money and how long that money needs to last. This is often overlooked in the rush to build a retirement plan, but it’s essential to how much risk your portfolio can handle.
Let’s return to Bob for a moment. Even though Bob had a low risk tolerance, his 10-year time horizon allowed for more risk in his investments. Why? Because over the long term, the stock market has historically trended upwards, even through periods of short-term volatility. With 10 years before retirement, Bob had the ability to ride out the bumps in the market and potentially reap the benefits of long-term growth.
For someone with a much shorter time horizon—say, just one or two years from retirement—their risk capacity would naturally be lower, as they would have less time to recover from any downturns.
The Importance of a Holistic Financial Approach
When planning for retirement, it’s important to take a holistic financial approach. Retirement planning isn’t just about looking at your investments in isolation; it’s about understanding how they fit into your overall financial picture. This includes considering factors like your spending strategy, tax situation, Social Security benefits, and more.
Take Sarah, for example. Sarah was extremely conservative with her investments, but when her financial advisor took a closer look, they found she didn’t need to generate as much income in retirement as she thought. By optimizing her Social Security claiming strategy and making her investments more tax-efficient, they were able to create a more balanced portfolio that still fit her low-risk preference but offered better long-term growth.
Standard Risk Questionnaires: A Starting Point, Not the End
You’ve probably come across risk tolerance questionnaires that ask things like, “How would you feel if your portfolio dropped 20%?” While these tools can provide some insight into your emotional comfort with risk, they often fail to capture the nuances of your full financial picture.
These questionnaires don’t always account for other important factors like your income, expenses, taxes, and retirement timeline. And they can be heavily influenced by your current emotional state or recent market performance, leading to results that don’t fully reflect your true risk capacity.
That’s why it’s essential to have in-depth conversations with your advisor about your goals, concerns, and overall financial life. At MOKAN Wealth, we use risk questionnaires as a starting point for discussion, not as the final word on your investment strategy.
The Power of Financial Education
Lastly, education is key to better decision-making. Many people don’t fully understand what risk tolerance or risk capacity means for their financial future. This lack of knowledge can lead to overly conservative or overly aggressive strategies, neither of which serve you well in the long run.
For example, Tom, one of our clients, was 58 and nearing retirement. He wanted to move all of his investments into safe assets like bonds and CDs because he feared stocks were too risky for someone his age. However, after learning about inflation, diversification, and the historical performance of various asset classes, Tom gained a better understanding of how to balance risk and growth. With this newfound knowledge, he embraced a more balanced strategy that supported his retirement dreams without compromising security.
Understanding the difference between risk tolerance and risk capacity is critical for building a retirement strategy that truly works for you. While it’s natural to let emotions influence your decisions, you also need to take an objective look at your financial situation and time horizon. By balancing these two factors, you can create a plan that aligns with your comfort level while ensuring long-term success.
Remember, retirement isn’t just the end of your working life—it’s the beginning of a new phase. By understanding your risk capacity and keeping an eye on the big picture, you can set yourself up for decades of financial well-being.
