Risk tolerance and risk capacity
How you build your investment portfolio hinges on two concepts: risk tolerance and risk capacity. If you have an accurate understanding of your risk tolerance and risk capacity, you can systematically create a portfolio that meets your needs. If you don't, you're basically throwing darts at a dartboard.
So you're asking: what's the difference, and why do they matter? I'll get there, but first a quick (I promise) review of investing fundamentals.
Investing 101: it's all about risk and reward
Your long-term returns are directly proportional to your short-term volatility. In other words, anyone who says that they can make a 10% return on investment every year is running a scam. The reason why stocks have higher long-term returns than bonds is because you're getting paid a premium for holding assets that will -- not can, but will -- take occasional short-term dips. The flip side is also true: if you want to hold assets that are relatively stable, you're going to end up paying a premium, and thus will have lower returns. Makes sense, right?
So how much volatility are you capable of taking on in exchange for higher returns? How much volatility are you willing to take on? The first is your risk capacity, and the second is your risk tolerance. Those are the high-level questions that will determine your portfolio's asset allocation -- how much is dedicated to stocks, bonds, and other classes of investments.
Risk capacity is a measurement of the answer to the first question above: how much volatility you're capable of taking on in exchange for higher returns. This generally is determined by your financial planning software (or your advisor's):
First, analyze the risk/return characteristics of the available model portfolios. There may be anywhere from three to ten or more, each at a different point along the efficient frontier.
Then, run a Monte Carlo simulation of your financial plan using each model. Just because you know the expected return and standard deviation (volatility) of a portfolio doesn't mean you know exactly how it's going to behave; every unique series of returns will create a different outcome -- for example, if the market takes a downturn right at retirement, it has a very different effect than if it happens twenty years earlier or later! The Monte Carlo simulation will run projections based on many different random series of returns -- generally 1,000 or more -- and determine how many of those projections succeed, where "success" is determined by your investments staying above zero without having to make any change to the plan.
Finally, determine which portfolios have a success rate higher than your desired threshold. In my experience, this is somewhere between 75-90%, depending on how much margin of error you want to have in your plan. In some cases, all portfolios may pass with flying colors. In others, some portfolios at one extreme or the other may be excluded. The remaining portfolios represent your risk capacity, the portfolios that your financial plan can safely support: not too conservative, not too volatile, but Just Right.
As you might imagine, the results of this analysis vary dramatically based on your personal situation. How much are you saving? What are your expenses? How soon are you retiring? How much do you already have in investments? What kind of income will you have in retirement? How will it be taxed? What's a conservative estimate of your life expectancy? And so on, and so forth.
Risk capacity is the analytical, emotionless side of the equation, representing the facts as they stand. Not to say that measuring risk capacity isn't an art -- it just doesn't necessarily bring your emotions into the picture. That job belongs to risk tolerance.
Risk tolerance has nothing to do with when you're retiring, or how much you've saved, or any of those other factors that go into risk capacity.* Rather, it seeks to answer a simple question: how volatile a portfolio can you stomach emotionally? How much money could you lose due to a market downturn before you started losing sleep, or -- worst-case scenario -- broke down and moved it all into cash?
Needless to say, measuring risk tolerance is a tricky business. After all, it's hard to say how any of us will emotionally react to a situation until we've actually experienced it! There are currently two popular methods of estimating risk tolerance:
1. Compare the negative returns of the available model portfolios during a bear market (for example, the Great Recession). Choose the one with the highest loss you can stomach; you can "tolerate" any portfolio with that level of volatility or lower. (Riskalyze, a popular risk tolerance software package, uses a variant of this method.)
2. Use a risk tolerance questionnaire. Ideally, this questionnaire doesn't ask questions that are covered by risk capacity (though some do, which muddies the waters); rather, they ask questions that are designed to predict your emotional risk tolerance. Also the questionnaire should be psychometric, and statistically shown to accurately predict behavior in the face of market downturns. Depending on your answers, the questionnaire should indicate the model portfolio with the maximum volatility that you can tolerate. (Finametrica, another popular risk tolerance tool, uses this method.)
Putting them together
So how do you use risk tolerance and risk capacity to pick a portfolio? The process is relatively straightforward: remove any model portfolios that are excluded by either the risk capacity or the risk tolerance test, and choose one of the remaining ones. There are three main methods of making that choice, depending on what you're looking for:
If you want to maximize your rate of return, choose the remaining model portfolio with, well, the highest expected returns.
If you want to minimize the chance of you not having to change your plan due to an unlucky sequence of market returns, choose the remaining model portfolio with the highest Monte Carlo success rate.
If you want to minimize the effect of a market downturn on your portfolio, choose the remaining model portfolio with the lowest volatility.
Sidebar: why is this important?
As you've seen, a lot of variables go into determining your investment portfolio, some of them situational, some are emotional. "100 minus your age in stocks" is a decent rule of thumb when you're getting started, and target date retirement funds are a great place to start if you just need to pick something (e.g. your 401(k) allocation), but there's a lot they leave out. As soon as you get the opportunity, it's worthwhile to do the in-depth analysis above -- and now you know why.
* Well, it's not technically true that risk tolerance has nothing to do with facts...directly. Whether you're retired may well have an emotional effect on your risk tolerance, if you feel more skittish about market downturns now that you don't have your salary as a safety net.