Retirement and Risk: The Difference Between Tolerance and Capacity

Maintaining the right balance of risk and safety in your retirement portfolio is essential to your long-term financial security.

When we think about recipes for well-funded retirement plans, we often start with some basic concepts. One of them is that investing is key to preparing for our post-work years. Within our investment portfolios, however, is a separate consideration — one that’s crucial to getting retirement right.

It’s the concept of risk.

Planning for our golden years requires us to understand exactly how much risk we can handle and how much we have to take in order to retire well. So let’s look at two key elements of risk and break out some strategies for assessing and preparing for your future in ways that allow risk to work best for you.

Tolerance and capacity: Two sides of the investment story
Risk is inherent in every portfolio. The effectiveness of our investing strategy relies on it.

First and foremost, risk refers to the possibility that our investments will lose value. If this happens in such a way or at such a time that it affects our retirement income, then if can have serious adverse effects on our post-career lifestyle. We may have to postpone or cancel trips to see loved ones. Or worse, we may have trouble simply paying the bills. The potential outcomes of taking risk include some unpleasant and challenging scenarios.

So, to better understand this important factor, let’s look at risk through two different frames: tolerance and capacity.

  • Tolerance: At its simplest, tolerance means the amount of exposure to downside that you can endure without becoming deeply worried and upset. That’s important because investors stand to make poor decisions when they’re rattled by such feelings. Investor tolerance is often measured in the financial advisor’s office via questionnaire-style assessments — e.g., “What would you do if your stock lost 30% of its value in a market change?”
  • Capacity: The concept of capacity is connected to the amount of money you need your investments to create so that you meet the financial goals you’ve set for your post-work years. While tolerance is about how much risk you can psychologically bear, capacity is about how much risk you have to bear in order to adequately prepare for retirement. Capacity is typically determined by considering your ROI, how much time you have left before retirement, and the income goal(s) you’ve targeted for your retirement years.

You must strike a balance between your tolerance and your capacity. You have to acknowledge your ability to handle risk, but you also have to hit your marks by making profitable investments along the way to age 65 (or so). In the next section, we look at ways to think about striking that balance over time.

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