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Understanding Risk Tolerance and Risk Capacity In Regards to Portfolio Construction

Understanding Risk Tolerance and Risk Capacity In Regards to Portfolio Construction

| October 16, 2017

The concept here is essentially that as your advisors, we should work to both understand your 'tolerance' (aka personal and emotional willingness) to take investment risk, as well as your financial 'capacity' (aka ability) to take levels of risk and still have a high probability of long-term success based on your goals and financial situation. We then need to blend 'risk tolerance' and 'risk capacity' appropriately to identify the final risk level for your portfolio.

The blending of these two factors is where many advisors make mistakes. These mistakes can be significant and costly. For example, one client may have high tolerance for risk meaning they are emotionally comfortable and have always been comfortable with significant fluctuations in the markets and the values of their investment portfolio. However, because they are going to be retiring in 2 years and will be replacing their income by drawing from their investment portfolio immediately upon retirement, their capacity for a significant drop in the value of their portfolio in the next 2 years or when entering retirement is lower than their high risk tolerance due to the limited time frame to recover from a precipitous drop. Therefore, we must go with a more conservative portfolio than the clients risk tolerance would suggest due to their lower risk capacity; however, we would still be more aggressive than another client client with both a very low risk tolerance AND a similar risk capacity.

This article is somewhat technical and detailed, but does a good job capturing how we blend together your risk tolerance and risk capacity to develop the risk level of your portfolio and avoid mistakes. We look forward to discussing this with you in more depth.

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Odyssey Wealth Design provides financial planning and wealth management to clients in Orange County, Irvine, Newport Beach, and around the country.