Risk Reminder – Financial Planning Before Investing!

 In Financial Planning

So, why do we believe strongly that investment management should not be commenced without financial planning?  Well it has to do with risk.  It is only through a comprehensive financial plan will you find the answers to your own risk capacity, risk required, risk tolerance and risk perception all very necessary components of a good investment plan.

You probably are most familiar with risk tolerance.  If you made some investments through an advisor in the last decade or so, you have probably been asked to answer or fill out a questionnaire.  It contained questions like –

When faced with a major investment decision, are you more focused on the possible losses or the possible gains?” 


 “Investments can go up or down in value and experts often say you should be prepared to weather a downturn. By how much could the total value of all of your investments go down before you would begin to feel uncomfortable?”

…and your answers were used to suggest a portfolio allocation to you.  The bulk of the questions on these questionnaires are aimed at assessing your Risk Tolerance.  In other words, they help your advisor assess how you will react to the ups and downs of the products or investments that you will purchase.  Risk tolerance is the emotional or psychological willingness to take risk and in action is the degree of variability in investment returns that you can withstand.  You will make bad decisions, at the wrong time, unless the ups and downs of your portfolio are within expected ranges.

What is not determined from these questionnaires is your Risk Capacity or your Risk Required.  Risk Capacity is the maximum risk your financial situation would allow.  Risk Required is the minimum risk needed to meet your goals.  Risk as a concept is about exposure to uncertain outcomes.  In investing, the common measure of risk is the volatility of the return experienced.  The riskier an investment the more variable the returns will be.  Risk Capacity can be thought of as your ability to accept those variations and Risk Required is the maximum variation you must accept.  So associate risk capacity with capability and risk required with must or required.

We can further narrow this down, by accepting that it is generally not a problem to experience too much return from our investments.  The more the money, the merrier we will be.  Therefore, from a practical sense, Risk Capacity can be thought of as your ability to accept negative returns of unknown size and frequency in the future. In purchasing terms, can you afford to take the risk?  If you are retired or near retirement, in order to determine whether you can accept future negative returns, it is necessary to evaluate when and what the returns will be used for.  If you spend $60,000 per year and your pensions, CPP and OAS provide you with $60,000 or more, you could be considered to have an unlimited Risk Capacity and zero Risk Required as it relates to your portfolio.  Since you do not NEED the returns, you have the ability to accept any and all future negative returns.  However, if you spend $60,000 per year and your other incomes only provide $20,000 then your portfolio will need to consistently provide $40,000 per year.  Negative returns in the future will impact your ability to maintain that $40,000 per year.  Depending on how many assets you have and a host of other factors, your Risk Capacity could be very little or very great.

This is why Financial Planning is absolutely essential for retirees or near retirees.  Unless your Risk Capacity is immediately determinable as unlimited, it is necessary to carefully evaluate your future spending and your future incomes from non-portfolio sources to determine your Risk Capacity.  How can you build the proper portfolio to deliver the necessary funds as needed and at the right time throughout your lifetime,  without determining acceptable future results and the frequency and size of negative returns?   And it is not just any financial plan you need, it is a Cash Flow based plan that is required.  Many advisors when asked to do some financial planning will perform a Goal-Based financial plan.  Goal-Based planning will generally work well for younger accumulators.  It will help determine what you need to do to get where you want to be and help you with what is necessary to get there.  Its weakness in portfolio planning for retirees is that Goal Based planning will generally not provide a good Risk Capacity assessment of the negative outcomes.  It will tend to report the Risk Capacity as the risk “necessary” to achieve the goals not the capacity to sustain the negative future outcomes. Likewise, it is very useful to understand your Risk Required.  Since variability brings discomfort, understanding your Risk Required lets you takes as little risk as you can, thus improving your feeling of well being.  Less discomfort around your investments is a valuable addition to a good stress free life.

Lastly, we are faced with Risk Perception.  Many individuals find it difficult to judge how much risk they are really taking.  When all the financial news is positive and you are seeing your portfolio expand and expand, it is easy to feel that there is no risk.  Likewise, when the news turns south, it is easy to begin to believe that your portfolio is dangerously invested. Evaluating your portfolio in reference to the Risk Capacity, the Risk Required and your Risk Tolerance will allow you to get a better handle on how much risk is being taken and why. Perception can move to real understanding.

If you are a retiree, or near-retiree, get a financial plan in place, but stick to cash flow based planning. If you are young and building wealth, start with a goal-based financial plan and move to a cash flow based plan as your risk capacity declines.   When you start accumulating, your risk capacity may not be unlimited but it tends to be very high.

So the next time your advisor asks you to just answer a questionnaire, ask them, “Is that it?”

Don’t miss our previous blog post discussing wealth decumulation and how it fits into your financial plan.

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