When markets are continuously on upward trends and hitting their latest ‘all time highs’ every other month, it is easy to think that such trends will either continue as the norm, or that any periods of volatility will be short-lived and inconsequential to long-term outcomes. Such attitudes can unfortunately lead to complacency as ‘things are all doing well’.
However, risk is an inherent and unavoidable part of investing whether the market is high, or not.
Many investors are comfortable with this in principle. They recognise that markets can be volatile and that higher risk investments often offer greater potential for long-term returns.
The challenge arises when market movements conflict with your real financial needs. This is where the distinction between risk tolerance and capacity for risk becomes critical.
Sometimes known as the ‘how well can you sleep at night if the market falls’ measurement, your risk tolerance describes how comfortable you feel with investment volatility. It is largely emotional and behavioural, reflecting how you react to market movements rather than the financial impact of those movements.
Someone with a higher risk tolerance may:
Risk tolerance is often assessed through questionnaires and can be a useful starting point. However, it only tells part of the story.
Being comfortable with risk does not automatically mean you can afford it.
Sometimes known as the ‘can you continue to eat if the market falls’ measurement, and also known as your ‘capacity for loss’, this is the objective and practical side of risk, shaped by your financial circumstances rather than your mindset.
It considers questions such as:
Your capacity for risk / loss is influenced by several factors including:
Even where risk tolerance is high, a lower capacity for risk can significantly limit the level of volatility that is appropriate for you to take with your investment portfolio. This factor is unfortunately missed by many investors.
A common investment planning oversight arises when investors focus solely on tolerance and overlook their capacity. It is not so much that individuals are deliberately overlooking their capacity for loss, but rather that they can occasionally not be aware of the concept.
This is often seen where significant sums are allocated to market trackers (by way of example, an all S&P 500 or Nasdaq allocation) as investors are attracted by strong historical performance without full consideration of how these investments align with personal timeframes and future spending needs.
While such assets can deliver strong returns over the long-term, a sharp market fall can be problematic if funds are required within a relatively short period, typically three to five years. In these circumstances, there may be insufficient time for markets to recover before capital is needed and very little you are able to do about it.
Whether markets will recover is a smaller part of the equation, as history suggests they often do, but whether your personal timeline allows you to wait for that recovery to occur is the key.
Effective financial planning balances risk tolerance with capacity for risk, rather than prioritising one over the other.
In practice, this can involve:
In addition, your investment portfolio should change as your circumstances change, even if your personal tolerance to risk remains unchanged.
The overarching question is not simply whether you are comfortable with the level of risk you are taking. It is whether you have the time, flexibility, and financial resilience to absorb potential losses during market downturns.
Ensuring that investments are aligned with both risk tolerance and capacity for risk helps reduce the likelihood of forced decisions at the wrong time and supports more resilient long-term outcomes.
If you would like to review how your current investments align with your personal capacity for risk, particularly in the context of upcoming life events or retirement planning, get in touch with us today and book your initial, no-cost and no-obligation meeting.
Send us an e-mail to contactus@pattersonmills.com or call us direct at +44 (0) 1908 503 741 and we shall be pleased to assist you.
Please note that all content within this article has been prepared for information purposes only. This article does not constitute financial, legal, or tax advice. Always ensure you speak to a regulated Financial Adviser before making any financial decisions.
