Risk Tolerance and Capacity: Will You Pass the Test?

Wednesday, August 9, 2017

Properly evaluating your risk tolerance and capacity prepares you for any financial scenario

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By Jed Collins

As a no-name NFL player, I had to show up to every practice and every game with no doubt I would be prepared for the rigors that would unfold. There was no scenario that I wouldn’t be ready for—that’s how a veteran prepares.

I line up and look at the safety who will be covering me. I know that the next play and the entire game will be decided on who has more left in the tank. My legs are heavy from the fourth-quarter drive, and I begin to hear coach’s voice in my head: “The conditioning test this week is 10 sprints. Ten sprints show everyone you are capable of finishing when it counts!”

Being a pro means no one is going to babysit you; if you don’t put in the work, you lose your job. I know the test is 10 sprints, but around my eighth rep I believe I’m prepared enough and I could tolerate fatigue if I needed to.

Before you can measure up against your competition or memorize a playbook, you must prove you are prepared.

I take off on the snap of the ball, hit my fifth step to break, and see the ball flying. Trying with everything I have to make the catch, my calf cramps and fatigue sets in. The ball lands out of my reach and the game with it. I thought I could stomach the fatigue at the end of the game, but by not running my last two sprints I was not prepared for it. I failed the test and lost the game.

football-practice-risk-brighton-jonesBefore you can measure up against your competition or memorize a playbook, you must prove you are prepared. Where does that question get answered? In the conditioning test.

In my last post, I discussed the requirements needed before you even play the game—being in correct shape for sports and having cash protected before investing. The next question is how to use the conditioning test in the financial world?

The financial conditioning test is measured similarly, but instead of sprints, we measure risk. The two ways to measure risk are:

  • your tolerance to stomach it
  • your capacity to withstand it

Risk tolerance is an emotional decision. Just like in my conditioning test, I decided not to run the ninth or tenth sprints. I felt I could stomach the scenario when they were needed. Unfortunately, that choice turned out to be more than I could handle.

Risk capacity is a measurement based on your current inflows and outflows. Instead of an emotional decision, the plan is constructed around your ability to contribute or pull money from your portfolio.

No one fully appreciates the difference between tolerance and capacity until the ball is in the air or an unplanned scenario comes to fruition.

Properly evaluating your risk capacity prepares you for scenarios such as:

  • your income stream being taken away and an unexpected bill comes due
  • the market pulls back and you are looking to purchase a home
  • an opportunity to invest is presented but your money is all tied up

No one fully appreciates the difference between tolerance and capacity until the ball is in the air or an unplanned scenario comes to fruition. Being unprepared for these scenarios means you are failing the financial conditioning test.

Our goal as athletes is to never be in a game unconditioned.

Our goal in personal finance is to never expose money to risk it cannot withstand.

Jed Collins serves as an advisor at Brighton Jones.


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