Risk Capacity

Two customers each tell their representative they are comfortable with sharp market swings. Cassian, 38, has a secure salary, a full emergency fund and no withdrawals planned for twenty years. Wendell, 66, is retired and must draw 40,000 dollars a year from the same portfolio to live on. The representative should recognise that the two men differ mainly in their:

1. A.Investment objectives, since one seeks growth and the other seeks income.The stem gives no difference in objectives. The difference described is the ability to absorb loss.
2. B.Risk capacity, since Wendell must draw on the portfolio and cannot afford to sell into a decline.Correct. Both report the same tolerance, but Wendell's need to withdraw sharply reduces his capacity to bear loss.
3. C.Risk tolerance, since an older customer is by definition less willing to accept volatility.Age does not determine willingness, and both customers state the same tolerance. Capacity is what differs.
4. D.Liquidity of their holdings, since both would hold the same funds.The funds are equally liquid. The difference is the demand each customer places on the portfolio.

Why: Risk tolerance is the customer's willingness to accept volatility, which both men report as high. Risk capacity is the customer's financial ABILITY to absorb losses without damaging their plan, and it depends on time horizon, income security and the need to draw on the assets. Wendell must sell into any decline to fund his living costs, so his capacity is far lower than Cassian's even though their tolerance is the same.

An adviser distinguishes the risk capacity of a client from the risk tolerance of that client. Risk capacity refers to

1. A.the amount of volatility the client says he is emotionally comfortable holding through.Wrong. That is tolerance, an attitude the client reports rather than a fact about his finances.
2. B.the rate of return the client must earn in order to reach the goal on schedule.Wrong. That is required return, which describes what the goal demands rather than what the client can withstand.
3. C.the amount of loss the client can absorb without putting a stated goal out of reach.Correct. It ties the measure to the balance sheet and the goal, which is what makes capacity objective.
4. D.the extent to which the client believes a particular investment is dangerous.Wrong. That is risk perception, which can be corrected with information and is not a limit on anything.

Why: Capacity is a financial fact drawn from the balance sheet, the cash flow and the timing of the goals, and it measures how much loss the client can absorb before a stated objective is put out of reach. Tolerance is an attitude, describing how much volatility the client is willing to live with, and the two frequently disagree. A complete profile records both, together with the return the goals actually require, because a recommendation has to respect the lower of what the client can bear and what the client will bear. Where capacity is low the allocation must reflect that however comfortable the client says he is.

Two clients of adviser Ingeborg Sandvik return identical scores on her risk-tolerance questionnaire. Rafferty Blaine, 34, is a tenured professor with a fully funded emergency reserve and a guaranteed pension. Marlow Deschamps, 34, is a commissioned salesperson with highly volatile income, no cash reserve and a large mortgage. The MOST accurate conclusion is:

1. A.They have similar risk TOLERANCE but sharply different risk CAPACITY, and the recommendations should reflect ability to bear loss as well as willingness.Correct. The questionnaire captured willingness only; their balance sheets and income stability produce very different objective capacities to absorb a drawdown.
2. B.Because the questionnaire scores match, an identical portfolio is suitable for both clients.Incorrect. Suitability rests on the full financial profile. Identical stated willingness paired with very different capacity supports different recommendations.
3. C.Risk tolerance and risk capacity are alternative labels for the same measurement, so no additional analysis is required.Incorrect. Tolerance is psychological willingness; capacity is objective financial ability. They are distinct inputs and frequently point in opposite directions.
4. D.Deschamps volatile income raises his risk capacity, because clients accustomed to income uncertainty absorb portfolio volatility more easily.Incorrect and backwards. Volatile income plus no reserve and fixed debt service LOWERS capacity, because a drawdown is more likely to force selling at depressed prices.

Why: A questionnaire measures risk TOLERANCE, the psychological willingness to accept volatility. It says nothing about risk CAPACITY, the objective financial ability to absorb a loss without derailing the plan. Blaine has high capacity: stable, secure income, a pension that behaves like a large bond holding, and a cash reserve that prevents forced selling. Deschamps has low capacity: volatile income, no buffer and fixed debt service mean a drawdown could force him to liquidate at the worst time. Suitability requires reconciling both. Where willingness and ability diverge, the prudent practice is to build to the LOWER of the two and document the reasoning.

Delphine Arceneaux expects to close on a house in about 16 months and has $95,000 set aside for the down payment. She tells her IAR she would like to squeeze a little extra growth out of the money in the meantime and asks about a small-cap growth fund. The IAR should recommend:

1. A.An intermediate-term corporate bond fund, because bonds cannot lose value over a period as short as 16 months.Incorrect. Intermediate bond funds carry real interest rate and credit risk and can and do lose value over 16 months.
2. B.The small-cap growth fund, because 16 months is long enough for equity markets to recover from a decline.Incorrect. Equity recoveries commonly take years, and small-cap growth is among the most volatile categories.
3. C.A money market fund, Treasury bills or a comparable cash equivalent maturing before the closing date.Correct. A known amount needed on a known near date requires principal stability, not growth.
4. D.A balanced fund holding 60% stocks and 40% bonds, which lowers risk enough for a 16-month horizon.Incorrect. A 60% equity allocation can still fall sharply within 16 months, which would leave her short at closing.

Why: Money with a known date, a known dollar amount and no ability to absorb a shortfall belongs in cash equivalents, full stop. A money market fund, Treasury bills or a short-term certificate of deposit maturing before the closing date protects the amount she must have. A 16-month horizon is far too short to ride out an equity drawdown, and a partial loss here does not merely reduce a return, it kills the purchase.