If you are one of the 947 companies that rely on us (taxpayers) for a free ride, this newsletter is not for you; if you are a taxpayer without the bailout luxury read on and learn about two types of risk, tolerance and capacity. Risk tolerance is behavioral based and risk capacity is goal based, each type is different but equally important in the process to knowing your investment goals.
Risk tolerance is the degree in variability of investment returns that you, the investor, are willing to accept. Anytime you invest, whether in large or small amounts, the potential to lose money is there.
Understanding risk tolerance involves knowing that we have instinctive behavioral biases. These biases may affect the decisions we make in life and as investors. An example is recency bias, which would cause you to be overly confident in a bull market and especially doubtful in a bear market. In reality, how the market is currently performing should not affect your confidence in your investment choices…. but many times it does. Recency bias is one bias of many, the takeaway is for us to realize emotions and biases are part of being human and need to be accounted for when investing. When you get upset in your everyday life, you know to step away, eat, or maybe even sleep before dealing with the issue. If you don’t take time to reset, you may overreact and regret what takes place next. You should do the same when dealing with your investments. Don’t let your emotions of the moment cause you to make an irrational decision.
Risk capacity is how much “risk” you can afford. To know how much “you can afford,” you need to have answered: 1. Why am I investing? 2. What is my time horizon? and 3. What is my risk tolerance? With those questions answered, you are well on the way to knowing your risk capacity. The following is an example of risk capacity evaluation.
1. Reason for investing? Retirement
2. Time Horizon? 10-30 years
3. Performance needed? You want $40,000/year from retirement until you pass
You currently have two investments, a pension and a 401(k). If the pension was set to distribute $40,000/year you could then say the 401(k) has an unlimited risk capacity. If you were not this blessed and the pension was set to distribute $20,000/year then your risk capacity for the 401(k) would be for your investment to grow enough to distribute $20,000/year over the 10-30 year period.
The next step will be to combine your risk capacity with your liquidity requirements (next newsletter).
Knowing your investment goal(s)
- Why am I investing
- What is my time horizon (next newsletter)
- What is my risk tolerance & capacity
- What is my liquidity requirements
- Choosing my investment goal
- Conservative Growth
- Preservation of Capital