Attitude to Risk Vs Capacity for loss

12.11.2020
Andrew Spaxman
Financial Planning

The difference between a perceived attitude to risk and actual capacity for loss can often be confused.

Depending on the stage of the investment cycle you are in, may have a greater effect on the level of loss you are actually able to take, and the level of risk you take on your investments may not correlate with this. 

The level of risk an individual is willing to take can have an effect on the future returns of an investment and this is usually driven by personality and knowledge, both of which, are intrinsic factors that only the individual in question can determine. That said, the capacity for loss will depend on the overall assets held, age, and any liabilities/expenditure requirements, which, will overall determine the ability to absorb any fall in value of the investment(s) held. The factors which help to determine capacity for loss, should be able to be obtained by an adviser from the standard fact-finding process, with an assessment able to be made without knowing the individual in question. 

Given recent market volatility, an individual may reassess what their perceived attitude to risk level is, if they have noticed a fall in their investment values; however, their capacity for loss is likely to be unaffected, if their personal circumstances remain unchanged i.e. remain in employment and no additional debt taken on. 

Using an example to illustrate capacity for loss and a given investment: a young employee starting out their career and investing in their workplace pension, is likely have a higher than average capacity for loss. This is because they are unable to access their pension for a considerable number of years. Their attitude to risk level is not correlated to this, as whether they are a low, or high-risk investor, the ability to access the pension remains unchanged. 

Alternatively, someone who is nearing retirement with a mortgage and holds a singular personal pension, may have accrued their value to date through a higher attitude to risk level; although their attitude to risk may remain unchanged, their capacity for loss has become smaller, as their scope for future earnings is limited and the mortgage liability has to be considered, as it is likely due to be paid off in the near future. The preservation of the pension value is now the key consideration, with the option of using the tax-free cash that is available to pay off the mortgage. 

Ultimately, there is no right or wrong attitude to risk level, as it is determined by an individual. Capacity for loss can be defined by an external party, such as a financial adviser, noting a more preferable investment or product choice, specific to the individual’s circumstances.

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