It’s Time to Stop Ignoring (or underutilizing) Risk Capacity
To download my six-page summary explaining risk capacity (NO SIGN UP FORM REQUIRED), click on the following link:
If you would like to try the client questionnaire that determines the “personal risk score” for consumers from the OnPointe Investment Risk Software (which includes both risk tolerance and risk capacity), click on the following link:
Risk Capacity has been, and continues to be, the red headed step child when it comes to helping advisors determine the risk level of investments they recommend to clients.
Most advisors and most investment risk software programs focus on investment “risk tolerance.” As all readers should know, risk tolerance is someone’s personal attitude about investment risk, e.g., how comfortable someone is with dramatic losses in their investment portfolio when the stock market goes negative. Risk tolerance is emotion based.
What is Risk Capacity?
It’s a bit tough to define so I’ll give you a few different ones:
A classic definition is the amount of risk you need to take in order to reach your investment goals (either asset accumulation, income in retirement, or both).
A different way to define risk capacity is whether an investor is in a position to assume risk and if so, how much (will negative returns adversely affect the investment goals/objective).
Risk capacity is an emotionless risk metric that only looks at the financial well-being of someone and then mathematically determines their ability (capacity) to take investment risks.
The following are the traditional items you’d look at to formulate someone’s baseline risk capacity:
- What assets do you currently have to reach your financial goal(s)?
- Are you fully employed, part-time, unemployed, or retired?
- What is your annual income?
- How much is in your emergency fund?
- What are your future financial commitments?
- When do you need access to your money?
Those who start with or have more assets, those who have full-time jobs and ones that are high paying, those who have more in their emergency fund than those who do not, those who don’t have minor children in the house and the expenses that go with them, and those who can wait longer to access to their retirement funds will have a higher risk capacity.
OnPointe Risk Software Adds Risk Capacity
OnPointe’s new client questionnaire deals with both risk capacity and risk tolerance. We are very excited and believe it will be yet another reason for advisors to dump programs like Riskalyze, Hidden Levers, and others and start using OnPointe.
OnPointe calculates a client’s risk capacity and risk tolerance as separate items. Advisors have access to both scores and OnPointe will flag the client if there is a large divergence (meaning the advisor needs to sit down with the client to discuss the divergence).
By adding risk capacity, OnPointe is not only providing a more accurate picture of what type of risk clients should be taking, but from a compliance point of view, adding risk capacity is a huge benefit to advisors when trying to prove suitability and avoid lawsuits.
Don’t let risk capacity be the red headed step child to risk tolerance any longer. It’s not only a useful risk metric but a needed one if you are to give the best and most suitable advice to clients. And there is really no need to forego discussing risk capacity with clients now that the OnPointe Investment Risk Software calculates and incorporates it into a client’s personal risk score.
Roccy DeFrancesco, JD, CAPP, CMP
Founder, The Wealth Preservation Institute
Co-Founder, The Asset Protection Society