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Plan Well, Retire Well

Saving and investing your money

More about risk tolerance and risk capacity

I've come across a couple of different articles this week about risk tolerance and risk capacity, after writing my blog post last week. (Maybe it's the same phenomenon as when you learn a new word that you think you've never heard before. But then you hear it 5 more times in the next week.)

The November issue of Money Magazine has an informative article, How Much Risk Can You Stand? by George Mannes. And through the end of November, they have arranged for readers to have free access to FinaMetrica's risk tolerance questionnaire, which the article says is one of better risk tools available.

One of the interesting points in the article is this: "Risk tolerance isn't about how much risk you ought to take when you invest; it's about how much you can take before you crack." Meaning, your risk tolerance (and the asset allocation that it would indicate) should provide an upper limit for the amount of risk (i.e., the amount of stocks) you could assume in your portfolio, rather than a target allocation.

The article also contends that a good risk tolerance assessment tool should limit itself to assessing your "appetite for risk" and not your risk capacity. I think it's important to assess both. But they are probably right that the two should be evaluated separately.

In an ideal world, your tolerance for risk, your capacity for risk, and the actual amount of risk in your portfolio should be in agreement. I have a target allocation for my household's investments; it is based largely on an assessment of our financial ability to withstand losses (risk capacity). I was curious whether it would also match up with my risk tolerance. So I took advantage of the free access to the FinaMetrica tool and got my risk tolerance score. While FinaMetrica does not provide advice about what an appropriate asset allocation would be for any given score, the Money Magazine article suggests a "comfortable ceiling in stocks" for various scores. I was very happy to see that my actual allocation was right in synch with the suggested stock allocation for my score.

But the thing I will take away is this: this number should probably be my maximum stock allocation, rather than my target. My husband and I stood firm with our investments over the past two years, other than doing some rebalancing which actually means we moved money from bonds funds into stock funds. So our risk tolerance was able to handle the craziness of the stock market during that time. But I need to keep a close eye on our allocation. If the stock market continues to make significant gains, we could quickly be over our upper limit for stocks and take on more risk than we want. If we scale back a bit on the stocks, we'll be less likely to exceed our level of risk tolerance before I get around to rebalancing again.

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