Dynamic risk capacity
Dynamic risk capacity is one of the innovations that sets Oxford Risk apart. This approach is a core component of the suitability process. It’s based on science, but the process is a very human one, built around the individual and their behaviour in the real world.
What is risk capacity?
Risk capacity is the level of investment risk that an investor can take without putting their future financial goals in jeopardy. It can also be viewed as an investor’s ability to take investment risk once their current circumstances and future aspirations are taken into consideration.
One common measurement advisers use to inform an investor’s risk profile is ‘Risk Required’. However, the use of Risk Required is fundamentally flawed.
Tools that simplistically assess the amount of risk deemed necessary to meet future goals too often encourage investors to take unsuitably high-risk levels that exceed the investor’s capacity or tolerance. This dangerous approach increases the chance of catastrophically failing to meet not only an investor’s goals, but also their more essential needs. Any indication that goals can ONLY be attained by taking higher risk than indicated by an investor’s tolerance and capacity should be a clear warning signal for investors to either save more, lower their expectations, or invest their existing wealth more effectively.
Instead of measuring Risk Required, advisers and investors should instead use a Dynamic Risk Capacity tool that is able to take into account all the interlinked moving parts of an investor’s evolving risk profile.
For example, big future spending expectations will lead naturally to a lower risk capacity – the more that needs to be set aside to fund future needs or goals, the less room there is to risk investment losses. This can be offset with substantial non-investable assets, which reduce the burden on investable assets to fund future requirements.
The main factors affecting risk capacity include:
The ratio of investable assets to total net worth.
The liquidity of other assets.
The degree to which future spending might be met using investors’ expected future income.
The investors’ spending needs.
The insurance investors have in place to protect both their assets and their earning power.
How does risk capacity differ from risk tolerance?
Risk capacity is a guide to how investors should act based on their circumstances; it is not about what they are inclined to do or what they actually do, but rather what they ought to do and what they sensibly have the ability to do.
Risk capacity therefore defines the spectrum of portfolios an investor is able to invest in, whereas risk tolerance defines the spectrum of portfolios the investor is willing to invest in. This is why risk capacity and risk tolerance should be used together when building a comprehensive risk profile.
How should risk capacity be measured?
The Oxford Risk approach is based on three core principles of what a risk capacity assessment should be.
Dynamic: While risk tolerance is a (relatively) stable psychological trait, risk capacity is inherently dynamic. So, where risk tolerance will only likely be affected by major life events – such as marriage, births and deaths – risk capacity changes constantly as goals, earnings expectations, asset prices and other factors ebb and flow.
Automatic: Working out risk capacity doesn’t require an onerous cash-flow modelling exercise, and so can be made largely or fully automatic.
Quantifiable: Communicating risk capacity requires more than a simple reference to the value of the investor’s home or cash holdings. A subjective interpretation of a snapshot cash-flow scenario or two is similarly insufficient.