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The Three Dimensions of Risk: Tolerance, Capacity, & Need

Summary

More wealth has been lost due to human emotions and the lack of sound, disciplined financial planning than to any bear market. The good news is that risk is quite manageable with the help of a trusted advisor and an understanding of three dimensions of risk: our own personal tolerance, capacity, and need.

That four-letter word

Risk. It’s undoubtedly the most powerful, attention-grabbing four-letter word in finance. To quantify and control it, financial economists and others have developed a staggering number of ways to measure it. Metrics such as beta, standard deviation, Sortino ratio, value-at-risk (VAR), and many others have all become commonplace in the investment vernacular these days.

But what does it really mean for an investor to read that her portfolio has a Sharpe ratio of 0.5, a beta of 1.2, or a standard deviation of 12%? Such measures lack context and meaning for real people; they’re little more than data in a vacuum. They don’t tell us how risk impacts our goals, our mental health, our taxes, or our families. Without proper context and meaning, conventional risk measures do little to help us make better investment decisions. So, what’s missing?

Well, quite a bit it seems. We need a completely different framework for how we think about risk—not just as investors but as real-world human beings. We need a framework that helps us make better investment decisions through an understanding of our personal tolerance, capacity, and need to take risk. Such a framework purposefully puts the asset allocation decision—how best to invest our portfolio—at the end of this exercise; it makes our portfolio slave to our needs, capabilities, and emotions rather than the other way around. To invest wealth without a clear sense of how risk affects us personally, either positively or negatively, is tantamount to embarking on a long journey with no compass, no destination, and no reliable means of transportation.

 

The three risk dimensions

Let’s first dispense with the fairytale that determining our optimal asset allocation is a formulaic exercise. I wish it were true, but it isn’t. The real world just isn’t that simple. For many, investing is emotional, balance sheets are complex, and our wants and needs vary widely. And it’s because of this that a better, more insightful understanding of the three dimensions of risk: tolerance, capacity, and need to take risk can help us make better investment decisions.

 

Risk Tolerance

A client’s desire to take risk refers to their individual risk tolerance. It’s our ability to stomach “losses” in our portfolios. Simply put, some of us are more willing to take risk than others. Working with a trusted advisor to help uncover how we feel about risk-taking can help better inform what our portfolios should look like. We can’t earn the returns we need to help achieve our goals if we can’t remain properly invested for the long term. Subsequently, it’s critically important that our portfolio reflect our intestinal fortitude for taking risk.

I put “losses” in quotes because losses are always relative to some (often psychological) high water mark in our accounts. For example, if our portfolio was up 1% yesterday but down 1% today, did we really “lose” money? What if our portfolio was down 5% last year but is up 7% since inception? The takeaway is that risk tolerance is often framed in terms of how we would feel given the possibility for portfolio declines over some relatively short time horizon (say, 6-12 months). My point is that those declines are measured relative to some (somewhat arbitrary) point in time in our minds and we should challenge ourselves to reflect on what it truly means to “lose money.”

Reassessing our personal risk tolerance from time to time with our advisors is important. Things in our lives change that may or may not have an impact on how we feel about taking risk in our portfolios. For example, the loss of a job or a loved one, a life-threatening diagnosis, or a major inheritance can all materially impact how we feel about taking risk. There are legitimate reasons for adjusting our risk tolerance, which is why, in our view, investors should reassess their risk tolerance often.

But we should tread lightly here. There are less legitimate, even dangerous factors that could influence our risk tolerance that we should be wary of. For example, short-term market volatility is an oft-cited rationale for why someone has suddenly become less risk tolerant. Too often, investors cave to their instincts and move to cash or more conservative portfolios at market bottoms, locking in losses and (often) sentencing themselves to a life of financial servitude. How many of us have—or know someone who has—moved to cash at the bottom of the market? Or in response to “bad news” that we thought would surely lead to future market declines? We all know investors who went to cash (or more conservative allocations) during the global financial crisis in 2008, the U.S. sovereign debt downgrade in 2011, or the COVID-19 pandemic in 2020. They were all decisions that were made purely due to the time-varying nature of our psyche’s inability to tolerate relatively short-term declines in our portfolios. The alternative is also true: After large market gains, investors tend to become overly confident in their investing abilities, often claiming that they suddenly have a high tolerance for risk. It’s during such times that we see increases in investor demand for more speculative assets like IPOs, SPACs, and cryptocurrencies.

While it’s important to ensure that our portfolios are aligned with our risk tolerance, it doesn’t mean we should invest based on our emotions—quite the opposite. We need to remember that we are the biggest risk facing our portfolios, not the stock market, politicians, or what might happen with interest rates or tax policy. More wealth has been lost due to human emotions and the lack of sound, disciplined financial planning than to any bear market. It’s the human element—shaped over millions of years of evolution to prepare us for things like droughts, floods, and lions—that presents the most risk in modern day financial markets. The good news is that this is a risk that’s quite manageable with the help of a trusted advisor. Whether that be someone here at Mercer Advisors, a close friend, or family member, having someone you trust with whom to discuss major investment decisions is important. But the first step is to know yourself; the second step is to surround yourself with others who know you and your situation and who aren’t afraid to hold you accountable to your actions. The takeaway is that a deeper understanding of our own risk tolerance—and an awareness of how our emotions change through time in response to external events—can help us make better investment decisions.

 

Risk Capacity

Risk capacity refers to our financial ability to take investment risk. Having a comprehensive understanding of our balance sheet and sources and uses of income is necessary to assess risk capacity. For example, a high earner or someone early in their career typically has a higher risk capacity than a low-income earner or someone later in their career. There are of course exceptions to this. For example, a high-income earner can still spend all or more than they earn, significantly reducing their risk capacity. Further, high levels of employment income may be misleading if those sources of income are volatile or unreliable. A tenured college professor with a stable income might have a greater capacity to take investment risk than, perhaps, a currency trader whose income may be quite volatile.

Similarly, those with larger balance sheets typically have higher risk capacity than those with smaller balance sheets. To some degree, this makes sense; the wealthier an individual, the more investment risk they can take. But there are exceptions here, too. To the untrained eye, a large balance sheet might seem to suggest a higher risk capacity, but that isn’t necessarily true if there are significant, unsustainable demands on the balance sheet. A $10 million balance sheet trying to sustain $700,000 in annual spending (7% withdrawal rate) likely has a lower risk capacity than a $3 million balance sheet trying to sustain $100,000 per year in spending (3.3% withdrawal rate).

While asset values can often be impressive (and overstated), liquidity also matters; just ask Lehman Brothers. When it filed for bankruptcy, the investment bank had $640 billion in assets, not because it didn’t have sufficient assets but because it had insufficient liquidity. Alternatively, balance sheet liquidity may be less material if we have large, non-balance sheet sources of income (e.g., income from employment). The takeaway is that a deep understanding of our financial capacity to take risk can help us make better, more informed investment decisions by contextualizing how changes in asset values might impact our financial situation more broadly.

 

Risk Need

Risk need is about understanding how much risk we need to take to help achieve our goals. It’s just math. The present value of our assets is our balance sheet. The future value of our balance sheet is what we need to fund our future goals. We connect the present value (PV) of our balance with its future value (FV) through time (N), savings/withdrawals (PMT), and investment returns (I). Since our savings ability for most of us is relatively fixed, we can easily solve mathematically for the required rate of return we need to achieve our goals. And since risk and return are linked, solving for the required rate of return tells us how much risk we need to take in our portfolios to help achieve our goals.

However, understanding the true nature of our balance sheet, and what’s truly ours, is critical to getting the math right. For example, consider 401(k) plans. Those vehicles, while great savings tools, mask an embedded tax liability; a relatively large percentage of those assets will ultimately go to the IRS in the form of taxes (typically 10% to 37% depending on the tax bracket). The same is true of taxable (non-retirement) assets with unrealized gains. Those assets today include an embedded tax liability as high as 23.8% of the unrealized gain, which may increase to 28.8% soon if current legislation becomes law.

It’s my view that this should not be interpreted as an opportunity to try to shortcut the math by investing in unrealistic strategies or asset classes promising high returns. While near-term portfolio returns are a function of market sentiment (momentum), asset allocations, valuations, and inflation, returns are largely random in the short run. However, they are, importantly, less random in the long run and hence more reliable. For example, despite staggering losses in 2008 and early 2009, by May 2011 the S&P 500 Index had fully recovered—about 26 months after it hit bottom on March 6, 2009. And despite those staggering losses, over the 10-year period from 2008–2017 the S&P 500 returned 8.49% per year.  It seems time—time in the markets— can indeed heal market wounds.

 

Bringing It All Together

Our resulting portfolio should be the product of alignment between all three dimensions of risk: (1) it should reflect our individual tolerance for risk; (2) it should consider our capacity for risk; and (3) it should include the requisite amount of risk needed to help achieve our goals. If at any point along the way these three dimensions are out of alignment, we need to step back and adjust. For example, if our risk tolerance declines at a time when our need to achieve higher returns increases, it’s time to make some hard decisions. If we’re intent on investing in a lower risk, and hence lower return, portfolio, then we mathematically need to save more, spend less or lengthen our time horizon if we’re to still achieve our goals. A trusted advisor can help assess and decide among such trade-offs.

The takeaway is that we’re empowered to make better, more informed investment decisions when we understand where and how risk tolerance, risk capacity, and risk need all intersect. It’s a place where risk, opportunities, and choices all come into focus, a place where we create the best possible context for us to achieve our economic freedom.

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Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. The firm only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.

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