Investing comes with risks. We have covered before why it is not a good idea to take more risk with your portfolio than you are willing to. Something else you need to get right is to not take more risk than what you can afford to take. We call this your risk “capacity”.
Imagine being faced with two hills. One has a great view at the top but is quite steep and rocky. The other does not have a great view but would be an easy walk. You can make it up the steeper hill in the time you have and you are willing to brave the terrain. However, if there were any delays at all going up the steeper hill you would find yourself coming down it in the dark. This is another scenario entirely. Also, you need to be somewhere after the walk and you really cannot miss it.
In this case what you are willing to do and what you should do are two completely different things. This is the same as the level of risk you are willing to take and the risk you can afford to take.
You do not want to take too much risk if you are going to need the money soon
An example would be someone having to pay for a holiday in a year. If they wanted to invest the money they saved for this, they should not put it somewhere risky. They could find they have less than they need in a year.
If they were willing to delay the holiday if the portfolio did not fare well, this situation could change. Being willing to go on a less expensive holiday could also change this. In these cases, taking some risk with the money might be suitable. The upside could be that a better holiday is possible if the portfolio increases in value.
You do not want to take too much risk if it is paying for something vital
An example would be taking monthly withdrawals from a portfolio to pay the mortgage. There would be no flexibility in these withdrawals. Not taking them would be unwise.
If the portfolio fell in value, each withdrawal would take a larger chunk out of it than before. This would reduce the amount of time the portfolio could last for. In this scenario, this could have significant consequences.
The scenario changes where it involved paying for something far less vital. Non-essential expenditure which you can adjust accordingly could be an example of this.
Building this into the plan
For all clients, we assess how long it is until they need their money. We also talk to them about what could happen and what they would do. We use this to inform them what levels of risk might be suitable. Another way we help is by reducing the impact of market downturns on income. This enables our clients to take more risk than they could have previously. We call these withdrawal strategies and we will cover them in a different post.