Risk capacity is your ability to take on investment risk. The more investment risk you take, the higher the potential return. However, higher risk also means a greater potential for loss and usually more fluctuations along the way. How much investment risk can you reasonably take while being able to reasonably expect that you will have the money that you need when you need it? Let’s mull this over and try to translate that into how much we can invest and an appropriate stock:bond asset allocation.
Consider your investment time-frame.
When considering your risk capacity, the time-frame is very important. The money has to be there when you need it as cash.
Money that you need in the short-term (less than 3 years) should not be invested. It should be saved. That could be in a bank account. If it is a year or two off, you could use a guaranteed investment certificate (GIC) that matures before you need the cash. Either way, you cannot risk investing it. It is a bad idea to rely on luck or working more to make up for an investment that goes even temporarily bad at a time when you need to liquidate it.
Money that you will need in the intermediate term 5-10 years from now is more complicated. You need to consider how flexible the spending need is and your ability to pay for it outside of selling investments. When you know that, you can use that information to determine an asset allocation where even if you are investing at the worst possible time now, your portfolio is likely to recover by the time you need the money (based on history).
Step 1: How much money do you need as cash for immediate needs?
The Expected. You want to keep enough money as cash for your month to month budget and allow for some of the variation in cashflow that life throws you. Plan for some unexpected costs that predictably happen, like vet bills, car repairs, or home repairs.
Plan for the unexpected. Have cashflow available to cover 3-6 months of your usual living expenses. Some will hold that as cash in a bank account. Others will have a line of credit available. Both approaches have their pros and cons. Everyone should have an appropriate amount of disability insurance and life insurance.
Plan for the predictable. If you are self-employed, make sure that you have enough money to also pay your quarterly tax installments. Again, a bank account or line of credit could fulfill this role.
Exclude this money from your investment plan and asset allocation. If you don’t have it, build it up before you start investing.
This can be done using a bank account. If you have a line of credit, then paying down your line of credit to reduce debt and make enough room to deal with emergencies or tax installments can also make sense. Key to using a line of credit as a financial buffer is being disciplined enough to pay it off and avoid using it to simply spend money that you do not have and will not have imminently.
Step 2: What big expenses do you have coming up in the next five years?
You don’t want to have to sell your investments to get the cash to pay for something at a bad time. In a bad secular bear market, stocks can go down and take many years to recover. These happen every 5-20 years or so. No one knows exactly when they will happen and it is not readily apparent until your investments are substantially down. You then don’t know when it will end either – until it does. Smaller or shorter market drawdowns are very common. Resist the urge to try and time the market. “Experts” have called 100s of the last 2 bear markets. But, protect what you must protect.
Step 2a: Considerations for your intermediate-term risk capacity & asset allocation:
- How much money could you lose before your planned big spend is reduced to a point you cannot accept?
- How long could you delay it or are willing to delay it to wait for the market to recover?
- Could you and would you work more or spend less to make up the difference if needed?
Step 2b: How rigid are those considerations?
The above questions help you define how much money you need to protect. How you do that with your asset allocation also depends on how much flexibility you have to adapt. That depends on your investment portfolio size and your future cashflow control.
If your portfolio is small and this money that you are investing is what you’ve got. Period.
You need to be sure that the money will be there when you need it. On the other hand, markets go up more than they go down the longer the time-frame you look at. You probably don’t want to completely miss out by not investing at all if you have an intermediate time-frame. Fortunately, mixing in some bonds makes portfolio drawdowns more shallow and the recovery time faster.
Canadian Portfolio Manager Blog did a great job using rolling time periods over 50 years to compare recovery time for different asset allocations. So, look at your time-frame and compare that to the time to recovery for different asset allocations in the table below, adapted from their findings.
If you cannot absorb any loss & your time frame is under 5 years, then a 40% equity and 60% bonds allocation would be the most risk you could take. If your time frame were >10 years, then even 80:20 is likely to be ok. The closer you are to needing the money, the closer you could be to one of those devastating max drawdowns. On the other side, if you have the flexibility to absorb a <5% loss or wait it out a few more years – then you could potentially consider a more aggressive allocation (provided it doesn’t exceed your behavioural risk tolerance).
If your portfolio is large (or will likely be large at the time you need the money).
You could make sure that the “safer” bonds portion of your portfolio is enough to cover your costs until the market recovers while also not making your portfolio so volatile that you can’t stomach it. For example, let’s say you have a planned spend of $50K and your portfolio is $1MM with an 80:20 stock:bond allocation. If there is a market drawdown, the bonds are likely down much less than the stock market. You would likely still have $100-$200K of bonds. So, you could easily sell $50K of bonds without changing your asset allocation too much. This type of strategy only works if you hold your bonds and equity separately. If you use an “All-In-One” asset allocation ETF, it would be automatically rebalancing all the time and you cannot sell the bonds instead of the equity portion.
The Peri-Retirement Risk Period & Sequence of Returns Risk
The point where our portfolio is likely to be the largest and our ability to make up for a market drawdown at an unlucky time is as we approach and the first few years of retirement. That is called sequence of returns risk (SORR) and it can impact whether your portfolio meets your long-term needs. One approach to mitigate SORR is to alter your asset allocation as you approach or are in early retirement. Another approaches is to have some cashflow flexibility from trimmable discretionary fat in your planned retirement budget. The other variable to manipulate in the SORR danger window is your income. Continuing some part-time or casual work when you have met your retirement portfolio goal can mitigate the financial SORR and help you with the psychosocial challenges of transitioning to retirement. If you are in the decade leading up to retirement, read some of the links in this paragraph and give this aspect of your risk capacity some thought.
Step 3: Choose an asset allocation suitable to your risk capacity.
Given the above information and reflection:
- Write down how much you can invest instead of save.
- Choose a stock:bond ratio for what you can invest.
- Don’t stress about it. If you do #1 properly, you have time to adjust #2 as you gain experience.
Now that you have assessed your financial ability to take risk, consider how much risk you can take and still be able to stick to the plan without your emotions getting you. Your risk tolerance.