Have you ever heard of Risk Capacity?
The vast majority of readers (I’d guess nearly all readers) are not familiar with this important risk metric. The reason is because most advisors do NOT incorporate Risk Capacity into their planning when working with clients.
I believe that Risk Capacity can be a vital tool when discussing with clients the best way to help them protect and grow their money before and in retirement.
What is Risk Capacity?
It’s someone’s financial ability to take risk.
Risk Capacity is different than Risk Tolerance which is how someone feels about losing money in larger stock market declines.
Risk Capacity is NOT based on emotion; it’s determined by the facts and circumstances of a client’s situation.
Put another way… Risk Capacity has to do with the impact a market downturn would have on your ability to reach your goals at a certain future point in time.
What factors are used to determine Risk Capacity?
Risk Capacity takes into consideration factors such as:
- Number of dependents (children and/or elderly)
- Employment status and in what industry
- Annual income
- Current savings
- Monthly expenses
- When you will need access to your retirement funds
In general, the younger you are, the fewer dependents you have, the more you make, the less you spend, the more you have in savings, and the longer you can wait to access your money would all increase your Risk Capacity (your financial ability to take risk).
Why is understanding Risk Capacity important?
Think about sitting down with a financial planner to put together a road map to your retirement. Most financial planners will focus on Risk Tolerance (how you would feel if the stock market went down dramatically).
Basing financial decisions mainly on emotion, in my opinion, is a mistake.
It’s my job as an advisor to give clients what I think is the best advice to help them accomplish their goals. If I allow emotion to drive all decisions, many clients will not be able to financially reach their goals (their fear of losing money will mean they fall short of accumulating the money they would like to have when retiring).
By incorporating the concept of Risk Capacity with clients in a discussion about the best way to protect and grow their wealth for retirement, it allows the client to see things in a less emotional way. It allows them to take a step back from some of their fears to realize that they may be in a situation where they CAN take more risk then they think when choosing the tools to grow their wealth.
Or on the flip side, some clients like to take risk. By discussing Risk Capacity, they may come to the conclusion that they are NOT in a financial position to take such risks.
Once you know Risk Capacity and Risk Tolerance scores, you will then be in a position to make more informed decisions and less emotional decisions about the best tools to use to grow and protect your wealth before and in retirement.
Risk Capacity is an underutilized tool in the financial planning community but is one that can and should play a vital role in helping people make less emotional decisions about their money.
You can learn more about Risk on our website, including getting your own Risk Score, by going to https://aspencreekfinancial.com/learning-about-risk/.
If you have any questions about Risk Capacity, feel free to contact us or schedule a call with one of our advisors on our website. We’d be happy to discuss the concept in more detail and help you understand your personal Risk Capacity.