Financial vs. Emotional Capacity for Risk: The Importance of Weighing Both When Building An Investment Portfolio

Your investment strategy should be determined by the lesser of (1) your financial capacity for risk and (2) your emotional capacity for risk. Otherwise, you are likely jeopardizing your financial goals.

What’s the difference you ask?

Financial capacity is the ability to achieve your financial goals even after a severe stock market decline.

Emotional capacity is the ability to stomach volatility and losses in a severe stock market decline.

A couple examples will help illustrate these concepts.

Financial Capacity

Levi is 65 years old with plans to retire in two years. He hires me as his financial advisor. The portfolio from his former advisor is invested 40% in bonds and 60% in stocks. His former advisor told him that was a moderate portfolio and prudent for someone his age.

The first thing I do is build Levi’s financial projections. As usual, we run multiple scenarios in order to identify the optimal financial blueprint for his unique circumstances. We determine that the current approach of targeting 40% in bonds and 60% in equities results in a 91% probability of achieving his financial goals, which is great!

We run an alternate scenario and find that a more conservative portfolio of 70% bonds / 30% stocks results in a similar 90% probability of success even though the expected long-term returns are lower. Not much difference in the probabilities.

Next, I run the market stress tests as I do for all my clients.

In Levi’s case, we stress his family’s financial goals against a severe bear market. We assume, in this bear market, that his bonds make 5% while his stocks lose 50%. This implies Levi’s portfolio, as currently structured, loses about 28% in the first year of retirement. We discover that Levi is actually quite comfortable with that degree of loss. After all, he’s been through many cycles over his lifetime and the market always comes back! However, due to the unfortunate timing of the bear market and proximity to retirement, the probability of achieving his financial goals decline to just 65%, well outside our comfort zone for someone in that age group.

We then apply the same bear market stress test to the alternate, more conservative 70% bond / 30% stock portfolio. The result is a much milder loss of about 11% in a severe bear market. Because the portfolio holds up relatively better, the probability of success is also much better at 78%, which is well within our comfort zone even after experiencing a severe bear market.

In this example, Levi does not have the financial capacity to take on the risk associated with his current investment strategy even though he has the emotional capacity for it. His former advisor steered him wrong, and Levi could have paid dearly for it.

Emotional Capacity

Assume that instead of the bear market stress tests resulting in 65% and 78% probabilities, the results were 76% and 79%, respectively. Not much difference between the two strategies this time. In both scenarios, Levi is in good shape, well insulated from a bear market and has the financial capacity for taking on the risk implied with his current investment strategy ( 40% bonds / 60% stocks). But does he have the emotional capacity for that risk?

Assume, upon reviewing the plan together, we discover that Levi is completely unsettled by losing almost 30% of his portfolio even though the probabilities look good. He would lose sleep and has a greater likelihood of abandoning the strategy at the exact wrong time, which would compound his problems. After all, he’s worked his whole life and sacrificed so much to build up that nest egg.

Therefore, even in this scenario, the more conservative approach remains the more prudent approach for Levi because his emotional capacity for risk is less than his financial capacity for risk. Therefore, emotional capacity would take priority.

Conclusion

Remember, your financial plan assumes you maintain the investment strategy and continue to rebalance back into losing investments throughout adverse markets. That means, in this example, selling bonds and buying stocks even after stocks lose half their value.

Sure, rebalancing sounds easy now, but it was very difficult to get even the most aggressive investors to rebalance back to stocks in early-2009 after stocks were down over 55% from their peak. In fact, most investors were looking to sell their remaining stocks because they “couldn’t take the pain any longer.”

Financial projections don’t assume investors sell when stocks are down 50%. The projections assume the investor is buying MORE stocks. So, if you don’t have the emotional capacity for a given level of risk than it’s unlikely you will stay the course and maintain your strategy let alone rebalance when required. The implication is that no matter how good the math looks, emotions will take over and you’re likely jeopardizing your financial independence.

Even if you have the stomach for risk but the math doesn’t look good than you don’t have the financial capacity for risk so you should adjust accordingly. This is why it is so important to have a financial plan that incorporates volatility and stress testing AND revisit it each year!

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