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What’s your Risk Capacity?

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AUTHOR: Rick Connor on 1/21/2025

A recent post by Dick Quinn asked an important question in personal financial planning – “do we understand our risk tolerance”. The post linked to an investment risk tolerance assessment. I took the assessment twice and received a similar score each time – an average/moderate tolerance for investment risk. I’m wasn’t surprised by the score, especially now that I’m retired.

Risk tolerance describes our “psychological willingness to take on risk”. Although there are likely some inherent aspects to our risk tolerance, I believe we can evolve our understanding of financial risks through education and experience. This can help at both ends of the spectrum; a very risk averse person may come to better assess investment risks and make reasonable choices, and a high-risk gambler may back off and take a look at index funds.

Although it’s important to understand our tolerance for investment risk, I think it’s more important to understand our risk capacity. Risk capacity measures our ability to handle financial risks.  Our risk capacity includes things like our income, assets, debts, and insurance. It could also consider our human capital, or our ability to work and earn income. A married couple with two high earning professionals likely can assume more investment risk than a family with a single earner. But if both earners work at the same company, they might share a risk of the business closing.  This happened to a number of couples I worked with during several mergers and plant closures.

The good news is we can improve our risk capacity by practicing sound personal behaviors. These are the behaviors we read about every day on HumbleDollar. They include working hard, growing your skills, living within your means, saving, investing, insuring, and leading a healthy lifestyle. More good news – these are activities we can mostly control.

Risk management was an integral part of the many complex projects I supported and led during my career. It’s also important in personal financial planning, and we can tailor it to our specific needs. It’s hardly an exact science, but the process of identifying, analyzing, evaluating, acting on, and monitoring risks is a big step in moving us to a secure financial future.

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Patrick Brennan
16 days ago

Warren Buffett, while speaking to a group of MBA students at the University of Florida just after the collapse of Long Term Capital Management in 1998, said something about risk I’ll never forget because it applies to so much more than financial risk. He said the guys at Long Term, “…risked what they did have and did need for what they didn’t have and didn’t need.”

Nassim Taleb, is his last book, “Skin In the Game”, talks about sequence of risk in his last chapter. Bottom line is never take risks that may result, as a potential outcome, in total ruin. Long Term did just that. Then there was the fellow who passed me riding a crotch rocket motorcycle on I-95 in Jacksonville, FL, about ten days ago, driving between the cars/lanes at about 100+ mph. He didn’t get the memo about avoiding activity that can lead to total ruin.

Patrick Brennan
16 days ago
Reply to  Rick Connor

You see this sort of thing with guys who seem to have it all, career and financial success, a nice family, etc. then they go and have an affair, get divorced, become estranged from their children, sometimes destroy their career, and get a whole lot poorer all over a really bad decision. Throw in a little alcohol and the odds go way up. (Why do casinos serve gamblers cheap or free drinks?). There is a rubicon there you don’t want to cross if you can help it.

Liz Brennon
16 days ago

The other thing to remember about risk propensity (from psychology research – especially escalation of commitment research – instead of bailing now to preserve what you have left you risk it all in hopes that you will get back all that you have lost so you don’t bail) is that when we look at things from the point of view of a loss or potential loss (eg are loss framed) we are more likely to take a risk/bigger than when we look a things from the point of view thinking about something as a gain/potential gain (eg are gain framed).

If there actually has already been a loss and we focus on the loss we are more likely to stay on that path and take a bigger risk to try to get it all back than if we view it from a gain framed point of view of if we bail now we will not lose more money in the future thus will gain that.

parkslope
16 days ago
Reply to  Liz Brennon

While acknowledging the fact that both notions reflect the fact that we hate to lose, decision-making researchers generally make a distinction between loss aversion and escalation of commitment in response to a losing course of action. The main distinction between the concepts is that escalation of commitment, which is embedded in the sunk cost fallacy, is not based on a comparison between how we value gains versus losses.

Rob Jennings
16 days ago

Could not agree more. In fact I just commented on Quinn’s post that collectively my wife and I have a low to moderate risk tolerance but due to a recent increase in our risk capacity, we upped our stock allocation. And, we plan to up it again in a couple of years when we have higher percentage of guaranteed income in our cash flow following a rising equity glidepath.

Eileen OHara
17 days ago

Rick, thanks as always for a thoughtful post. The phrase ‘it’s easier to bet the farm when you don’t have a farm to bet’ comes to mind.
I also think of risk capacity when building a career (taking more risks?), caring for family (being present at expense of higher pay?), deciding when to retire.
And today, from the vantage point of my 60s, I watch young adults navigating their early careers in an environment where the prospect of AI and other economic forces could drive more uncertainty and fear around creating financial safety. Despite the low unemployment rate, many professionals across many fields have been out of work for over six months(per a recent Wall Street Journal article and firsthand experience with a relative). Others are doing extremely, extremely well (health care PAs, finance, consulting and data science professionals I know in their mid20s). Still more under 30s want to pursue traditional careers in education, where good teachers are still desperately needed. How to encourage them to understand ‘risk’ more deeply and to make thoughtful decisions whatever their income?

Jack Hannam
19 days ago

I always enjoy your thoughtful treatment of “risk” from the perspective of an engineer. When I read “risk” in the financial literature, I ask “risk of what?” I prefer Buffett’s definition of risk as the probability of permanent loss of capital. Price volatility is used as a proxy for risk. Are stocks risky? Assuming proper diversification, the risk in owning them is dependent on my behavior. The probability that I would sell during a severe drop in prices is the question. As a retiree I can lower that probability by keeping sufficient assets in cash and short to intermediate term treasurys to avoid the need to do so when taking withdrawals. And by having sufficient risk tolerance, or to put it another way, volatility tolerance, I could ignore the price drops, or take advantage by doing some rebalancing. Bernstein wrote of the need to consider first the capacity to take risk, then the need to take risk before considering your personal tolerance of taking risk.

Norman Retzke
18 days ago
Reply to  Jack Hannam

I perceive personal financial risk in terms of a failure to achieve reasonable goals. Ultimately, will my financial plan fund all of our life event goals and expenses?

Last edited 18 days ago by Norman Retzke
Jack Hannam
18 days ago
Reply to  Rick Connor

That is a great answer, Rick. Individual ingredients, when looked at in isolation may seem too risky, or provide too little yield, but how the overall portfolio performs is what matters. When it comes to financial management, I like dull.

Jeff Bond
19 days ago

Rick, you worked on risk management of satellites in order to make sure they survived for the duration (and beyond) of their mission. For a time I worked design of equipment for use in nuclear power plants. In my case, the goal was to survive the possible impacts of earthquakes, tornados, and other naturally occurring disasters. The safety factors imposed for these designs were very high – another way of managing risk. The goal was always to deploy equipment with designs that were safer than any expected occurrence.

Unfortunately, sometimes “everything” isn’t addressed. In the nuclear industry, there have been risk instances that were not considered: Chernobyl and Three Mile Island issues could be attributed to operator error, and Fukushima might be attributed to poor natural disaster planning and/or design. Thankfully, I did not work on any equipment at these three plants. There have been space-based errors, too. The Hubble was initially deployed with faulty optics (in some, not all, cases) and there was the Mars Climate Orbiter that failed due to a problem with units conversions.

I’m just sayin’ – – – risk is out there. There are always scenarios that aren’t always fully understood or considered.

Marjorie Kondrack
19 days ago

Rick, Thank you for this thoughtful article. Risk capacity is all important. Security is one of the things we strive for all our lives, but in all too many cases, the bigger risk is not taking the risk.

We often resist making changes because we fear the unknown, but the wise person takes calculated risks. If we have the courage to pursue our convictions, unfavorable odds shouldn’t keep us from pursuing what we know intuitively we were meant to do.

R Quinn
19 days ago

Rick, do you think the two can be separated? As you said, risk tolerance is psychological and capacity physical/mathematical.

I would say at this point I have a high capacity, but that doesn’t change my tolerance.

In fact, I’m guessing that in some people the higher the capacity the lower tolerance as they may be even less inclined to put what they have accumulated at risk.

R Quinn
19 days ago
Reply to  Rick Connor

I can’t say I ever actually worried about money, there wasn’t much to waste, but I always had a pretty secure job, regular raises and we always lived within our means.

I still don’t like to take much risk and it bothers me on a day when my portfolio drops considerably. Today my one stock has dropped and that bothers me although for no logical reason.

My problem is I set a goal to reach and don’t like going backward.

Marjorie Kondrack
19 days ago
Reply to  Rick Connor

Rick, your mention of Jonathan made me think—what better example of a successful entrepreneur, who left a prestigious job to be on his own. There comes a time when it’s time to stretch our talents and enlarge our capacities.

Marjorie Kondrack
19 days ago

Added: I hope I made clear the connection to Risk Capacity in referencing Jonathan’s choice. It takes an unusual amount of capacity for risk and a deep belief in ourselves to do what he did .

Liz Brennon
16 days ago
Reply to  Rick Connor

It also implies you know when you have “won” rather than having winning a moving target.

Edmund Marsh
20 days ago

Thanks for this article, Rick. As I read your list of behaviors, I thought of an individual with whom I’ve had a few conversations about finance over the past several years. He was once extremely averse to investment risk, and suspicious of the means to do so. This was partly wrong-headed because of ignorance, and partly justified due to the behaviors he exhibited. With education and some moderation of his behaviors, he has accepted more risk and is on a better track toward building wealth.

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