Risk Capacity - Adviser report Overview Video
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Definition
Risk Capacity is a measure of an investor’s ability to take investment risk.
To be precise, it is a calculation of the level of risk that investors are able to take with their investible assets today, given their current assets, liabilities, and expectations of future cashflows (e.g. inheritances, expenditure, goals, and gifts).
Calculation
Risk Capacity is calculated as the ratio of the investor’s overall wealth to their investible assets.
Overall Wealth
An investor’s overall wealth includes the net value of the current balance sheet (i.e. assets minus liabilities), plus their net future cashflows.
Investible Assets
These are any and all assets which the investor is prepared to invest in a diversified portfolio at their Suitable Risk Level. Any liabilities held against such assets are considered part of Current Liabilities.
Some investible assets may be held elsewhere – this is fine. Compass will automatically work out the right level of risk to take with the Investible Assets you do have control over, to balance out the risk of externally-held portfolios.
Net Non-investible Assets
These are assets which the investor cannot invest in a diversified portfolio, such as individual properties, equity in single businesses, valuable collections etc.
They should be adjusted to reflect the net value as appropriate – for example, mortgages should be subtracted from property assets.
When providing asset details, investors can indicate their willingness to sell them to fund expenses. This is only an approximation, because it is very hard to put a number on willingness – and we believe it is better to be roughly right than precisely wrong.
Current Liabilities
This includes debts such as loans or other lines of credit, including borrowing taken against investment portfolios.
Net Future Cashflows
Expected future income and planned withdrawals should be considered as part of an investor’s overall wealth.
This is related to the notion of “human capital”: young people have considerable expected future income, part of which will be used as contributions to their pensions. In the early stages of their careers, their pension pots are very small relative to their future size, and therefore should be invested at a high level of risk.
Net future cashflows, however, includes both expected income as well as foreseeable spending, including goals.
But because the future is highly uncertain, we incorporate a progressively stronger dampening effect on these cashflows. This is to ensure that Risk Capacity is considerably less influenced by income or expenditure anticipated more than five years hence.
When providing details of expected future income, investors can indicate roughly how certain they are that it will happen. Similarly, investors can specify how flexible they are about planned expenditures, and their importance.
These approximations are used by Compass to reflect investor perceptions about future cashflows in their overall Risk Capacity, without attempting to be spuriously precise about every detail.
Simplified Risk Capacity
Instead of a holistic view of an investor’s wider wealth, Compass also offers a simplified version of Risk Capacity.
This ignores non-investible assets and extraneous cashflows – i.e. the focus is solely on a single investment portfolio and any inflows to it / withdrawals from it.
Risk Capacity with pensions
If an investor has a pension portfolio to be considered, then it is worth considering the Risk Capacity of their aggregated investments and their non-pension investments distinctly.
This is because a pension which an investor cannot yet access could, in some circumstances (i.e. when Risk Capacity of aggregated investments is low), act as a spur to take on undue risk. In such cases, we perform a separate calculation of Risk Capacity specifically for non-pension investments.
Outputs
Risk Capacity is expressed verbally as either Low, Medium or High, depending on its calculated value. Also we account for the bands in the between, Moderately Low and Moderately High.
The table below contains the full range of outputs:
| Risk capacity | Description |
| Low (<1) | Your total net wealth is smaller than your investible assets, which means you need to protect your wealth by taking lower risk with your investible assets. |
| Medium (=1) | Your total net wealth is approximately equal to your investible assets, which means you should invest at the level of risk indicated by your risk tolerance. |
| High (>1) | Your total net wealth is larger than your investible assets, which provides you with a buffer to take a much higher level of risk with your investible assets. |
How to use it
When an investor’s total net wealth is large relative to their investible assets, their portfolio risk is effectively diluted. This happens because the investor’s non-investible assets are large, and/or their future income is greater than their planned expenditure. So, they should take more risk with their investible assets to compensate.
On the other hand, Risk Capacity is low if the investor’s total net wealth is less than their investible assets. This could happen if they have debts, and/or their planned expenditure exceeds their income. They should reduce the risk taken with their investible assets to reflect this.
Compass can automatically calculate how to take Risk Capacity into account when arriving at an investor’s Suitable Risk.