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Risk Tolerance and Risk Capacity

Investing Insights General

Someone recently asked me for some career advice in a situation that essentially boiled down to a choice between something more aligned with her previous work experience and something tangentially related but less likely to be seen as a traditional “next step” on her current career path.

The first option is safe; the second is riskier but offers a unique opportunity, both in terms of culture and experience.

Some might expect a boring financial planner to suggest the safer option, since it has more certainty and stability. But I suggested the latter.

This person is in her mid-20s and has few family and financial obligations. Her capacity to take a risk like this is far greater than, say, someone in her mid-40s with three kids under 18. If this job opportunity doesn’t work out – or even if it’s just short-lived – she will still be eminently hirable in her current field, and potentially even more in demand given the experience she will acquire. That’s a risk worth taking to try something new, exciting, and different.

That calculus flips when there’s a mortgage and college expenses to consider. In that case, the potential rewards probably have to be significantly greater to outweigh the risks. Even if a person in that situation has the tolerance to take such a risk, they might not have the capacity to do so if things don’t work out as planned.

Conceptually, our approach to personal finances – particularly our investment portfolios – follows a similar pattern. Some people are inherently risk tolerant. They love roller coasters, eating questionable food from street vendors in foreign countries, investing in highly volatile stocks, jumping out of airplanes...you get the idea. Other people broke out in hives just reading that sentence, let alone trying any of those things. Both sets of people will be drawn to different investment portfolios, with the corresponding risk/return nature of those portfolios.

The financial world supposed has tools to measure risk tolerance. (Full disclosure: I use such a tool when working with clients, and I think almost all of them are terrible.) But less discussed is someone’s risk capacity: how capable are you of handling things if a particular risk doesn’t work out? That’s less an inherent trait and more an understanding of your baseline financial position. Someone who only has $1000 to their name probably shouldn’t bet it all on the Kentucky Derby, regardless of their comfort level of doing so. Alternatively, someone with $1 million can probably do that, even if it’s ridiculous to do so. Yes, the loss wouldn’t feel great, but it wouldn’t cripple them financially.

That’s why the ideal investment portfolio merges these two concepts. Can you put together a portfolio that gives you the greatest likelihood of achieving your goals in such a way that you both don’t bail when things get ugly (because things always get ugly) and that won’t completely destroy you if things don’t work out exactly as planned?

Additionally, we need to realize that while our inherent risk tolerance may not change much over time (and there’s decent data to back this up, outside of the impact of recency bias after a major event), our risk capacity very well may.

The young woman who asked my advice has the risk capacity to take the unusual job offer right now. She has little to lose outside of time, and lots to potentially gain.

Earlier, I suggested that someone older with more obligations may not be in the same position. With a limited cushion, a setback to someone taking such a risk could be devastating if things don’t pan out, particularly if there’s less time to make up for any losses.

But age and time don’t need to necessarily be the rate limiting factor. What if the cushion wasn’t limited? In twenty years, if that person has done a good job of saving and planning, it’s possible that she could have built up enough of a base to try a similar risk.

Put more concisely, risk capacity can be situationally dependent, where risk tolerance may be built more into our DNA.

I hope everything works out for this young woman in her potential new venture. But even if it doesn't, she’s going to be fine. She’s learning a great lesson in taking calculated risks when she’s capable of bearing the cost of potentially being wrong. Regardless of the outcome, that’s an incredible lifetime return on investment.