Most investors have filled in a risk questionnaire at some point. These questionnaires usually measure one thing: how comfortable you feel with the possibility of losses. That matters, but it is only one of three questions a sound strategy should answer.
What does risk actually mean for an investor?
For most investors, risk is more than short-term ups and downs. It is the chance of not meeting an important goal, or of being forced to sell at a bad time. Volatility, permanent loss of capital, inflation eroding purchasing power and running out of money are different risks, and a plan should consider each.
Holding only cash can feel safe, yet over long periods inflation can steadily reduce what that cash will buy. Equally, a portfolio that looks diversified may still fall sharply in a crisis. Being clear about which risks matter most to you makes the three questions below easier to answer.
What is the difference between risk tolerance, capacity and need?
Risk tolerance is how much uncertainty you can live with emotionally. Risk capacity is how much loss your finances can absorb without harming your goals. Risk need is how much risk your goals actually require. A sound strategy considers all three, and pays particular attention when they point in different directions.
What is risk tolerance?
Risk tolerance is psychological. It describes how you are likely to feel, and act, when your portfolio falls in value. It matters because a strategy only works if you can hold it through difficult periods. An investor who sells in a panic during a downturn may lock in losses that a calmer investor would have recovered from.
Tolerance is harder to measure than it looks. People often answer questionnaires more boldly in rising markets than in falling ones, and the experience of a real decline can change how someone feels. Talking through how you reacted in past downturns, if you have invested through one, is often more revealing than a score.
How can you test your risk tolerance before markets do?
One practical approach is to translate percentages into amounts. A fall of 20 per cent sounds abstract, while seeing what it would mean in your own currency is far more concrete. If that figure would lead you to abandon the plan, the plan may carry more risk than you can realistically hold.
Hypothetically, on a portfolio of 1 million, a 20 per cent fall would mean a paper loss of 200,000. Some investors can watch that happen and stay invested, while others cannot. Neither response is wrong, but the strategy should match the one that is true for you.
What is risk capacity?
Risk capacity is financial. It depends on your wealth, income, commitments and time horizon. Someone with secure income and decades to invest can usually absorb a temporary fall in value more easily than someone who will need the money next year, however either of them feels about it.
Capacity can differ across the same person's wealth. Money set aside for school fees due in two years has little capacity for loss, while capital intended for the next generation may have a great deal. This is one reason it can help to plan different pools of money separately.
What is risk need?
Risk need is the level of return, and therefore of risk, that your goals require. Some goals can be met with modest returns, while others need more growth. If your goals require more risk than your tolerance or capacity allows, adjusting the goals, the timeline or the savings rate may be wiser than adjusting the portfolio.
Need is sometimes lower than people expect. An investor who already has enough to meet their goals comfortably may have little need to take significant risk at all, even if they could tolerate it. In that case, extra risk adds uncertainty without adding much that matters to them.
How do the three work together? Three hypothetical investors
Consider a hypothetical investor with high tolerance, low capacity and moderate need. They are comfortable with volatility, but need part of their savings for a property purchase in two years. A sensible plan would limit risk on the money needed soon, whatever their appetite, and treat longer-term money separately.
A second hypothetical investor has low tolerance but high capacity and low need: a retired professional whose pension covers their spending and whose savings are well above what they need. They can afford risk but do not need it. A cautious portfolio may suit them well, and there is no reason to push them further.
A third hypothetical case is the most difficult: an investor whose goals need high growth but whose tolerance and capacity are both low. Here the honest answer is usually not a riskier portfolio. It is a conversation about saving more, working longer, spending less or adjusting the goal.
What happens when the three answers conflict?
A conflict between tolerance, capacity and need is useful information, not a failure. It shows where a trade-off has to be made. In general, capacity should act as a limit, tolerance should shape what you can realistically hold, and need should be tested rather than accepted at face value.
It is better to discuss these conflicts openly at the start than to discover them during a market fall, when emotions run high and the options are fewer.
How often should you reassess your risk profile?
Reassess whenever your circumstances change materially, and at regular intervals in between. Marriage, children, a business sale, retirement, an inheritance or a move to another country can all shift capacity and need. Tolerance can shift too, particularly after experiencing a significant market fall for the first time.
Avoid changing your risk profile only because markets have moved. Reassessing after a sharp fall can lead to selling at a low point, and reassessing after a long rise can encourage more risk than your plan needs. The trigger should be a change in your life, not in the headlines.
What are the common mistakes when assessing risk?
- Relying on a single questionnaire score.
- Treating all of your wealth as one pot with one risk level.
- Taking more risk than your goals require simply because you can tolerate it.
- Ignoring how you actually behaved during past market falls.
- Revisiting your risk profile only after markets have moved sharply.
Key questions to take to your adviser
- How have you assessed my capacity for loss, separately from my comfort with it?
- What level of return do my goals actually require, and how confident are we in that estimate?
- Should different parts of my wealth have different risk levels?
- What would a significant fall in value mean for my plan in practice?
- What changes in my life should prompt us to reassess?
A suitable strategy sits where the three answers overlap. Understanding each one separately makes it easier to find that overlap, and to stay with the strategy when it is tested.
Sources and further reading
This article is for general education only and is not personal financial, investment, tax or legal advice. Speak with a qualified adviser before making decisions about your own situation.
