Monday, 25 November 2013

Risk Capacity: What is your capacity and does it match your tolerance?

Last week's post on risk tolerance mentioned that an investor's own financial situation can create more or less leeway to withstand the bad effects of poor investing results without permanent catastrophic harm, a feature we called risk capacity. We promised to look at what exists online to help an investor assess his/her own risk capacity, so here we go. The ultimate goal is to find the best investing strategy, specifically the mix of different types of investments, asset classes like cash / Treasury Bills, domestic or foreign equities, corporate or government bonds, REITs, or commodities, to combine into an asset allocation for the portfolio.

Risk Capacity - the key aspects

  1. Time Horizon(s) - The longer before you need any or all of the money, the higher your risk capacity. Equities have historically on occasion gone through long periods of ten or fifteen years being underwater following market collapses. It is a big plus to not be obliged to cash in equities after a horrible down year such as the 40% 1973 dive of the TSX Composite and to be able to wait through the six year recovery period ( as bad as it was, the 2008 crash was only 34% and a mere two year recovery). Recognizing different time horizons for different goals e.g. house purchase in five years, university education in 18 years and retirement starting in 30 years pulls risk capacity in different directions. Tools or questionnaires that recognize such circumstances will produce a truer assessment. Some questionnaires ask too ambiguously about "when the money is needed back". It's not necessarily all or none - in retirement, one may turn an RRSP into a RRIF and withdraw small amounts to spend while continuing to seek some growth. 
  2. Wealth - No doubt the world's richest investor Warren Buffett has little need to hold bonds or T-Bills to protect his modest lifestyle in case of a stock market decline. Conversely for someone with no other savings, a $1000 decline in a $10,000 portfolio verges on calamity. The more you have, the more you can put afford to put at stake, or as is often said, afford to lose. It's net worth, after deduction of debts, that is the relevant figure. Having to continue making payments on debt like a mortgage but not needing to count on the investment portfolio to provide cash is one reason we often hear the advice to always hold three to six months emergency cash reserves.
  3. Other Income & Human capital - Economists call our lifetime earning power human capital. The higher your non-investment sources of income like salary the more likely it is there is a surplus or savings that buffers against any need to liquidate investments in a down market. Of course it is possible to use up any amount of income with too lavish a lifestyle, which is why some questionnaires go a step further and ask about your current savings rate. The other important aspect of the other income is how stable it is. A tenured professor has great job security while teachers and civil servants rate high as well but a commission salesperson or an hourly paid worker in a cyclical industry has a much less secure and reliable income stream. Professor and author Moshe Milevsky elaborates on the investing consequences in his book Are You a Stock or a Bond? (yes he does rate himself a bond) A secure income is equivalent to bond income while the less secure among us are the stocks. Given the huge proportion of almost everyone's personal lifetime income that comes from work earnings, factoring in your job to the decision of how to structure your investment portfolio, is a critical step. How much time you have left to earn makes a big difference too. Many questionnaires will therefore ask about your age and/or time before retirement. Some questionnaires will also use age to draw conclusions about time horizon though that is not the best way to do it. Salary is not the only possible source of other income. Canadians have access to Canada Pension Plan and Old Age Security payments after retirement. Some fortunate workers may be part of a solid defined benefit pension plan. Owning rental properties is yet another source. All these sources serve to increase the capacity to withstand bad effects when investment risk happens.

Figuring Out Your Own Risk Capacity
Questionnaires combine risk attitude and capacity - Unlike the questionnaires devoted only to risk attitude/tolerance, there are no questionnaires for risk capacity alone. Even the better questionnaires on risk capacity that we found all mix in risk attitude and some risk perception as well. It is therefore more difficult to discover any marked divergence between risk attitude and capacity, which is what we want to find out in order to think about and reconcile the two.

Index Fund Advisor Risk Capacity Survey - These US-based fund managers offer a short 5-question survey and a more complete 25-question long survey. It is well worth the extra few minutes answering the 25 question version. At the end, there is a question by question explanation of what your answer means, along with links to other parts of their website with in-depth explanations on the topic. An extract image of part of a sample output is below. The survey concludes with an overall stock vs bond recommended allocation. This is the best and most detailed questionnaire we found.

Mulberry Chartered Risk Profile and Capacity for Loss Questionnaire - This questionnaire is also only in pdf form so one must manually total the score for the 11 questions. Five questions address capacity and six risk attitude. It is meant for use by an advisor with a client so we have to do the usual DIY thing and be our own advisor to draw our own conclusions. Its unique feature is that it rates your capacity for loss separately, on a scale from Low to High.

BMO Insurance Investor Profile Questionnaire - Of the 11 questions, five relate to risk capacity, two to investing goals and the others to risk attitude. The questionnaire is only in pdf form so one must manually add up the score. The slots the investor into one of four types of portfolio - Conservative, Balanced, Growth or Aggressive, but no asset allocation recommendation is given. On this questionnaire we found that the risk capacity sub-total did not align with the risk attitude sub-total. The risk attitude questions seemed constructed in a way that caused our own answers to skew much higher than they should.

Vanguard Investor Questionnaire (USA) - Though Vanguard now has a Canadian arm, the website is not as extensive as the original one in the USA and it does not have a risk profile questionnaire. The US questionnaire consists of 11 questions only, half of which are devoted to risk attitude and the other half to risk capacity. The total score leads to one of nine possible recommended proportions of stocks and bonds, ranging from 100% stocks to 100% bonds. The scoring scheme puts enormous weight on the time left before beginning to withdraw income. There is no explanation of results.

Try all of them and look for consistent results - Rather than rely on any one of them, the thirty minutes or so that it will take to fill them all in lets us see how consistent the results are. Obviously, the more consistent the better since that means the various question wordings don't skew the answers and we can be more confident of being shown the right track.

Risk capacity should align with risk attitude - It's a bit more work to do since we must add up the sub-total score for the capacity questions alone but that gives us the ability to examine the all-important match-up between risk tolerance / attitude and capacity. Compare the capacity result with the tolerance answers from the FinaMetrica and Oxford questionnaires that we wrote about in last week's post. That will go a long ways towards reducing the divergence between what the questionnaires recommend and what investors end up doing.  It's an important potential failing of such questionnaires, as Preet Banerjee recently wrote in the Globe and Mail.

When this blogger did a personal comparison with last week's risk attitude questionnaire results, we generally did find convergence towards a 60% stock / 40% bond portfolio. But that is only our personal results for our own situation so every investor should do his/her own.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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