Risk Capacity vs. Probability of Success
4 October 2017
One of the most common misconceptions among Financial Planners is that they are evaluating their client’s Risk Capacity (or as the SEC describes, the client’s “ability” to take risk) when they run a Monte Carlo simulation designed to estimate probability of success. This misconception may stem from the scenario where an older client simply spends too much money relative to their asset base and retirement income. In such cases, the client’s probability of success is reduced simply because they are drawing money from their portfolio faster than their assets can be sustained in a material percentage of prospective scenarios. Their ability to take risk is also reduced because they are withdrawing a larger percentage of their assets in a shorter time frame, thus limiting the risk that each withdrawal can sustain.
Before we take a look at a very different example to illustrate how these two metrics are in fact quite different, let’s first contrast the definition of each concept.
Risk Capacity (i.e. ability to take investment risk) is a current measurement of how much risk a person can take based on their cash-flow chronology, unrelated to their willingness to accept risk (personality towards taking risk). In this context, risk capacity and ability are used interchangeably. While that capacity will generally evolve through time as they age, their risk capacity is a measurement of current ability to take risk. By contrast, a financial plan typically computes the client’s probability of success. This is a measurement of the entire period of time… generally current date through end-of-life or some proxy for end-of-life. These are two distinct concepts.
Now for an illustration to dispel the misconception.
Consider a young person who is saving diligently for the down payment on their home, which they plan to buy in a year. Their risk capacity (ability) might be quite low right now, as much of their liquid assets will be used in a year. In other words, the short-term nature of their capital need prevents them from taking too much risk without compromising their ability to meet the desired goal. After they purchase their house (and withdraw that capital), it is likely that they will continue to save throughout the remainder of their career, and their probability of success (as demonstrated in a financial planning tool) could still be quite high. Using their probability of success to make a recommendation about appropriate risk for their investments would be misguided.
As an aside, since the SEC (and FINRA) identify Risk Tolerance as both the client’s willingness to accept risk as well as their ability to take risk, it is preferable for fiduciaries to evaluate these two concepts independently of each other. The encompassing risk tolerance, and thus current recommended risk directive, is based on the more constraining of the two dimensions, which can change through time as their ability to take risk evolves. In the example above, after the purchase their house their remaining assets may have a much longer time horizon, causing their risk capacity at that point to be substantially higher.
As fiduciaries, it is incumbent on Investment Advisors to incorporate readily available information into the advice they provide a client. Most pundits acknowledge that something as readily available as the client’s cash-flows needs to be incorporated into advice as important as a recommended risk directive. To supplement comprehensive financial planning tools, Advisors need to utilize technology to facilitate a fiduciary caliber risk tolerance assessment which estimates both willingness to accept risk as well as ability to take risk. The output of such an exercise, when based on realistic client assumptions (good technology will validate the premise concurrently), becomes a powerful input (asset allocation) in the comprehensive financial planning process.
To learn more about the Fiduciary caliber risk tolerance assessment process, register for the FPA’s webinar on November 30th, 2017.