From Adviser Guide:
Updated Risk profiling
Q: What does ‘risk capacity’ mean?
This refers to a customer’s capacity for loss, i.e. the amount of risk they can afford to take based on the amount of money they are willing or able to lose.
Capacity for risk is determined by the resources available and the consequences of a loss of capital or income.
Risk capacity has to do with whether, for a given level of risk, the individual’s financial situation can withstand the impact of a worst case outcome.
Paul Resnik, co-founder of FinaMetrica, said: “Imagine that your mother decides she’d really like to learn to ride a skateboard, so she goes out and buys one.
“You try to talk her out of it, because while she may have the appropriate risk tolerance for it – after all, she was the one who decided to try it – she doesn’t have the appropriate risk capacity because she could easily break a hip or something equally incapacitating.
“So you give the skateboard to your eight-year-old son and suggest that he use it. He doesn’t want to try it because he knows that his friends have had accidents and he doesn’t want to get hurt.
“This is just the opposite situation. He has the risk capacity – he’s not likely to break anything and even if he does, he’ll recover quite easily. But he obviously doesn’t have the tolerance, the psychological inclination, for this type of risk.”
Mr Resnik said a client’s risk required may be achievable through a portfolio that could fall by 30 per cent and such a fall may be consistent with her risk tolerance but an evaluation of her risk capacity shows she can lose no more than 10 per cent without putting her important goals at risk.
He said: “Risk capacity is an absolute measure and overrides the other two. Advisers must be readily able to evaluate risk capacity by analysing the client’s financial circumstances using financial planning software.”