Retirement and Risk: The Difference Between Tolerance and Capacity

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When we think about recipes for well-funded retirement plans, we often start with some basic concepts. One of them is that investing is key to preparing for our post-work years. Within our investment portfolios, however, is a separate consideration--one that's crucial to getting retirement right.

It's the concept of risk.

Planning for our golden years requires us to understand exactly how much risk we can handle and how much we have to take in order to retire well. So let's look at two key elements of risk and break out some strategies for assessing and preparing for your future in ways that allow risk to work best for you.

Tolerance and capacity: Two sides of the investment storyRisk is inherent in every portfolio. The effectiveness of our investing strategy relies on it.

First and foremost, risk refers to the possibility that our investments will lose value. If this happens in such a way or at such a time that it affects our retirement income, then if can have serious adverse effects on our post-career lifestyle. We may have to postpone or cancel trips to see loved ones. Or worse, we may have trouble simply paying the bills. The potential outcomes of taking risk include some unpleasant and challenging scenarios.

So, to better understand this important factor, let's look at risk through two different frames: tolerance and capacity.

Tolerance: At its simplest, tolerance means the amount of exposure to downside that you can endure without becoming deeply worried and upset. That's important because investors stand to make poor decisions when they're rattled by such feelings. Investor tolerance is often measured in the financial advisor's office via questionnaire-style assessments -- e.g., "What would you do if your stock lost 30% of its value in a market change?"

Capacity: The concept of capacity is connected to the amount of money you need your investments to create so that you meet the financial goals you've set for your post-work years. While tolerance is about how much risk you can psychologically bear, capacity is about how much risk you have to bear in order to adequately prepare for retirement. Capacity is typically determined by considering your ROI, how much time you have left before retirement, and the income goal(s) you've targeted for your retirement years.

You must strike a balance between your tolerance and your capacity. You have to acknowledge your ability to handle risk, but you also have to hit your marks by making profitable investments along the way to age 65 (or so). In the next section, we look at ways to think about striking that balance over time.

Maintaining the balanceThe timing of investment strategies can affect the relationship between tolerance and capacity. Consider the following examples.

Early planners: When you have three or four decadesbetween now and your anticipated retirement age, your tolerance can typically stand to be higher. Even if you take a moderate loss early on, you have plenty of time to recover; you're not so close to retirement that capacity is creating the sort of pressure that it will in coming years. However, if you find you're a low-tolerance investor, keep in mind that a bond-heavy portfolio won't build a cushy retirement account like a stock-dominated portfolio could.

Mid-career planners: For planners whose working life has entered the middle phase, approaches to risk might change. Even if your tolerance is high -- i.e., if you like to shoot for high returns even if you take more significant losses along the way -- the realities of your financial situation could mean that you should reduce your risk somewhat. A married mother of three and a freelance artist might not be able to tolerate as much risk as, say, a single woman who got ahead with her start-up's well-timed IPO. For the average mid-career retirement planner, capacity may dictate a process of steadily reducing portfolio risk.

Flush or frugal? As you approach retirement, the relationship between your capacity and assets will largely determine how you create and maintain your fixed income. If you end your career a billionaire, then congratulations: Even if the risk you take exceeds your capacity, and even if you take a loss because that risk doesn't pay off, you'll likely still have the liquidity to keep up car payments, mortgage payments, and the like. However, if you're a more typical retiree, tolerance and capacity will likely play a more delicate role in your decisions. For example, when it comes to this type of retiree, experts at Schwab recommend a portfolio along the lines of 40% cash-and-bonds coupled with 60% stocks (their proposal is predicated upon a $1 million retirement account fueling $50,000 in annual income).

The key is to address the roles of these elements in your retirement planning -- now. And remember, tolerance doesn't always conform to answers on a questionnaire. Be prepared to flex if your portfolio hits a rocky point along the way. In reality, that 30% loss could seem more painful than you had expected when you filled out that questionnaire. Consult with your financial advisor and configure your portfolio so that risk tolerance and risk capacity work for you in acceptable --and sustainable --ways.

The article Retirement and Risk: The Difference Between Tolerance and Capacity originally appeared on Fool.com.