Observations on Risk Tolerance and Risk Capacity

The famous Temple of Apollo at Delphi—an important source of prophetic wisdom for the ancient Greeks—is well known for the two inscriptions on its portal:

  • Know Thyself
  • Nothing in Excess

As several world capital markets continue to flirt with record high asset price levels, it is worth revisiting Delphic wisdom in order to prepare for forthcoming dips in portfolio value.

Here are a few observations that are worth some thought:

During times of financial crisis, some investors sell their entire portfolio. They do so not because they have run out of cash with which to pay current bills. They do not hit a single point in time where they face insolvency unless they sell everything immediately. Rather, they suffer from emotional bankruptcy. They are afraid that they will realize irreparable harm to their portfolio or lose all of their money. Fear spikes upward, and their emotional time horizon decreases from the long-term to today. . In times of financial distress, it is not necessarily economic comfort that takes top priority; it is emotional comfort. Investors who sell their entire portfolio are investors who are willing to pay an extraordinarily high cost for a scarce good—emotional comfort. In most cases, when portfolio values decline, investors are inclined to make decisions on an emotional time horizon that is far shorter than their financial horizon.

Know Thyself.

Investing is a prudent exchange of risk. If you voluntarily sell assets during a downturn (“Sell low”) only to plan to reenter the market when it recovers (“buy high”), you do not avoid risk—you merely exchange one type of risk for another. Every investment decision (or “non-decision”) is risky. This is merely a restatement that the risk of excess fiscal conservatism may be as onerous as the risk of retaining assets lacking principal guarantees.

A careful assessment of risk entails an analysis of how much risk you are willing to take AND how much risk you are able to take—both willingness and ability. Willingness is often estimated by answering the question:  how much of your financial aspirations are you willing to sacrifice for short-term safety?  What’s your personal tradeoff between paying for long-term needs (required return) and stability of current wealth?  The concept of ‘willingness,’ in the financial context, has little to do with comfort and much to do with ability to sustain temporary downturns. It is an oxymoron to seek ‘comfortable investments’ because all investments earning above the risk-free rate have uncertain future payoffs.

The more you need to earn to reach your investment goals, the less your capacity for risk–because if you lose anything, you’ll be proportionately far more distant from your goals–and yet, the more risk you may need to take if you are to have a hope of reaching them. An adequate and sustainable future income (especially when considered in terms of its purchasing power) can demand that you own a portfolio with up and down values. It is the long-term income generating capacity of a portfolio (perhaps for future generations as well as for its current owners) that is of greatest importance in risk assessment. Risk willingness and risk capacity must be in balance.

Nothing in Excess.

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