Risk Tolerance vs. Risk Capacity
The genius in this piece of research arises from its simplicity. What we have done is taken hypothetical losses to a portfolio ranging from 10% to 60%. We then calculated how much return would be required to offset that loss (The idea being that if you lose 50% you must make greater than 50% to “get back to even”, etc.). Finally, we took the average one year annualized performance of a 60% stock, 30% bond, 10% cash portfolio and determined how many years it would take to experience the required return to offset the loss.
The lesson to be taken from this is simple: while you may have the tolerance to handle a 40% portfolio loss, do you have the capacity for your portfolio to take 7.1 years to make it back? If you are young and still actively saving, then then answer is probably yes (plus your systematic saving, dollar cost averaging, is going to reduce that 7.1 year time period). If you are very near retirement or in retirement and living off of your portfolio, you may not be able to afford waiting 7 years to get “back to even”. This is why the true value in money management isn’t “how much you make”, but it also encompasses “how much you keep” when things get ugly!
