Risk tolerance v risk capacity: when investing for income in retirement

There are many ways of determining the right level of risk when investing for income in retirement. However, one of the simplest and most useful ways is by looking at the twin concepts of “risk tolerance” and “risk capacity”.

Risk tolerance

Risk tolerance refers to the amount of risk you, as an investor, are able to tolerate psychologically. This will generally depend on your character, age, income, and financial goals. In short, it can be boiled down to how much risk you feel comfortable taking on.

Risk capacity

Risk capacity is more measurable than risk tolerance. It refers to the level of risk that you will need to take on in order to achieve your financial goals – i.e. the rates of return needed in order to reach a desired level of retirement income.

Many investors, find that there is a disparity between their risk tolerance and risk capacity. To the lay investor such a disparity may feel like an insurmountable problem. However, with expert and personalised advice, it is possible to bridge this gap with a path that balances the needs for retirement investing with level of comfort.

Finding the best retirement funds to invest in

Different financial advisers use different metrics to measure risk tolerance; they might look at standard deviation or upside/downside capture ratios but almost all use a risk profile questionnaire to provide statistics that will reveal qualitative and quantitative results. These statistics produce a risk-aversion coefficient that translates into and matches quantitative portfolio construction; which enables an adviser to recommend the best retirement funds to invest in.

Determining your level of risk

Risk tolerance and risk capacity may be useful notional tools, but a more fundamental concern is what you actually want your portfolio to do. As such, you should reflect and determine why you’re investing for retirement, according to the following considerations:

• Do you want to preserve your wealth and maintain current levels of purchasing power throughout your retirement?
• Are you hoping to grow your wealth in order to achieve a particular end value, perhaps for the benefit of beneficiaries or big ticket retirement spending?
• Is it your intention to live lavishly and spend everything?

Alongside a measurement of your risk tolerance via a questionnaire, an investment adviser should ideally discuss your retirement investing requirements with you face-to-face in order to understand what type of portfolio is likely to be right for you. It is this personalised approach that can help avoid some of the problems associated with so-called robo-advisers (online platforms which use algorithms to provide information on risk and suitability, before advising how to invest for retirement), when the total effect of risk tolerance, time horizon and income requirements has not been sufficiently explored.

Expat wealth management for informed retirement investing

For more than three decades Blacktower Financial Management has been an expat wealth manager helping clients across the globe identify their goals, and how to go about investing for retirement, as well as their risk capacity and risk tolerance so they can protect and grow their wealth in line with their dreams.

We can help you decide on a realistic goal and strategy while helping you to avoid the many potential investment mistakes and pitfalls. Contact us today for more information around finding the best retirement funds to invest in.

Disclaimer: This communication is not intended to constitute, and should not be construed as, investment advice, investment recommendations or investment research. You should seek advice form a professional adviser before embarking on any financial planning activity.