Risk Tolerance vs. Risk Capacity – the Very Important Difference

Given the way the year has started, there are many out there wondering what, if anything, they should be doing with their investments. Should they be selling and parking proceeds in cash? Should they be buying because everything is much cheaper than it was 2 months ago? Should they be doing nothing at all?

Whatever the action, a large part driving the decision making process in such volatile times should be based on risk management. Which is why the subtle distinction Christine Benz of Morningstar recently wrote about is something I thought it best to pass along. The following excerpt from one of her recent articles, “Maybe You Should Sell Some Stocks,” is especially apropos to retirees. It all comes back to the subjects of sequence of returns and time horizons…


Risk Capacity Trumps Risk Tolerance
Some investors hurtling toward retirement might argue that they have a high pain threshold. They've been stress-tested and they know they can handle the volatility that can accompany a high equity weighting. They didn't freak out in 2008, and they may have even added to their stock holdings on weakness.
But there's a difference between risk tolerance and risk capacity. Risk tolerance is how much you can lose without feeling psychic discomfort. Risk capacity, by contrast, is how much you can lose without changing your plans. As you get closer to retirement, your risk capacity declines, even though your risk tolerance may still be that of a 30-something.
If you haven't built up enough short-term reserves because you've been focusing on your risk tolerance instead of your risk capacity, your retirement plan is that much more vulnerable to sequence-of-return risk. That means that if you encounter a lousy equity market early on in retirement and need to spend from the declining equity portfolio, that much less of your investments will be left to recover when stocks finally do. Your only choice to mitigate sequence-of-return risk--assuming your stock portfolio is in the dumps and you don't have enough safe investments to spend from--will be to dramatically ratchet down your spending. Needless to say, that's not something most young retirees are in the mood to do.
Further compounding the case for derisking a portion of your portfolio if you expect to retire within the next 10 years is that valuations, while not exceedingly expensive currently, aren't especially cheap, either. That means that investors selling today aren't selling themselves out at distressed levels, even though the market has stumbled a bit recently. The typical stock in Morningstar's coverage universe was trading at a roughly 11% discount to fair value as of Feb. 3, 2016. That's not too discouraging, but many of the bargains are clustered in cyclical segments of the market like basic materials and energy. Due to global economic malaise, they could stay down for a while. The so-called Shiller P/E ratio tells an even more glum tale.

Bottom line, while conventional wisdom often says to ignore the noise, not everyone should sit still through the market’s turbulence. Retirees should consider what the ramifications of having to draw a steady income and poor market performance will be on their portfolio and adjust accordingly.