Capacity for Loss is the amount your investment portfolio can fall without having a material impact on your lifestyle.
Sounds technical doesn’t it. It is meant to be about risk, the amount of risk that people can live with, not what they think they can stomach. There have been cases where clients (when completing their risk profile questionnaires), have said they could stand seeing a portfolio falling in value by 35 – 40%. When it does happens it can often be a different story. It is important to remember that a drop in the value of a portfolio is not a loss, it is a temporary decline. It is only when an investment is sold that a temporary decline is crystallised into a permanent loss.
This is risk. It is the chance of investments declining in value. That is why we always advise that clients invest for a period of at least 5 years. In fact, most of our clients will likely be invested for anywhere is excess of 25 years plus, some until the time of their death.
Volatility can be best described as the ups and downs in the market. Everyone has seen images of the stock market (it doesn’t matter which index – the FTSE100, S&P 500, Nasdaq etc) – the general trend is the same. From left to right there is a squiggly line going up and down. If we look at the line over a short time horizon it may seem that it is going down or just standing still. If we look at the same squiggly line over the long term, we generally find that the trend is that the line moves from the bottom left to the top right of the chart – it is growing over time.
Investment risk and volatility are not the same. Therefore, capacity for loss is the amount of investment risk that someone can live with. Can the question of capacity for loss ever really be answered then? Probably not because life gets in the way and plans change. In truth most people want to know that they will be ok. They don’t give a jot about capacity for loss in the grand scheme of things. The only way to consider how much a portfolio can fall by (and for the client to be ok) is to have a financial plan which lays bare the truth about their money.
As financial planners it is our job to always tell the truth about money.
It is no secret, markets have been more volatile this year than in recent years. Some daily market movements have been by more than 2% in a day, which is something we haven’t often seen in recent years. Those who are putting money into cryptocurrencies are seeing daily movements in double digits. Definitely not for the faint-hearted.
We can’t control how the markets work. We can only really help to advise on how much volatility is in an investment portfolio (based on the balance between growth and defensive assets) and how people react to volatility. We can build the financial plan to uncover the truth about money and what might happen in the future. When talking about risk, volatility, capacity for loss etc, a financial plan is essential. It provides context as to how life might look if something happens or doesn’t happen. It allows us the scope to say that “if markets suffer a temporary decline of x% then it might mean you run out of money when you are aged whatever.”
A financial plan gives us the ability to help ensure that a client is always aware of what is going on with their money – be it good or bad.
Your Biggest Threat
The biggest threat to the success of any financial plan however is inflation. This is especially true at the time of writing this when inflation is in double digits (a high not experienced since the 1980’s when I was slightly younger and still in nappies!). For the value of money to have any chance of retaining its purchasing power then it needs to be invested (because it just won’t get there with cash as we have especially seen in the past 15 years!).
When I had my first pint of beer, way back in 1998, it likely cost around £1.90*. Now it would cost about £4.50 (and that is cheap – certainly not Belfast prices where it would be £5.00 – £5.70). In the 24 years (almost) since my first pint the cost has increased by 136%.
So, the real risk to a financial plan is not being able to afford a pint of Guinness (please feel free to put in here other things like tennis membership, wine, eating out etc).
*https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/czms/mm23
As always, investments can go down as well as up, and you may not get back the full amount you originally invested.
This should not be construed as advice. Everyone’s situation is different, so please seek professional advice.