Capacity for Loss

  1. capacity for loss should be considered as a distinct part of the fact find process, separately to attitude to risk
  2. advisers should consider non-financial issues such as lifestyle and wellbeing, which may also impact a client’s propensity to withstand losses
  3. cashflow planning is a good way of demonstrating to consumers the effect of losses on their future financial situation
  4. capacity for loss should be reviewed on a regular basis in the same way that attitude to risk is regularly considered
  5. advisers should include specific reference to capacity for loss within any client correspondence regarding the client’s investment choices.

The FSA’s reference to “how much risk an investor is willing and able to take” has led to the conflation in many cases of two distinct considerations, namely ‘willing’ and ‘able’.

Broadly speaking, the amount of risk an investor is willing to take can be seen as your risk appetite; the amount of risk an investor is able to take, on the other hand, is more akin to your capacity for loss.

Distinction
The distinction between risk appetite and capacity for loss becomes clear if we consider an investor who is prepared to accept a large amount of risk in order to receive potentially greater returns: in other words, they have a high risk appetite.

However, if it transpires that their investment is intended to fund an imminent retirement, their ability to accept loss – their capacity for loss – is going to be low.

According to ‘bird in the hand’ theory, investors tend to prefer to collect certain returns than risk loss in exchange for greater gains. Faced with a choice of receiving £450 or flipping a coin, the outcome of which is receiving £1,000 or nothing, only 8% of Britons would flip a coin: they would rather receive the guaranteed prize than risk receiving nothing.

The other way around, however, when the choice is either giving £450 or flipping a coin to give £1,000 instead or nothing, 25% of Britons would chose to flip a coin: they would rather not lose anything, so will gamble the coin flip. In other words, most investors are inherently risk averse.

Two factors
Capacity for loss ultimately depends on two crucial factors: the time horizon of the individual, and what the money is intended to be used for. For example, if a young investor starts saving for retirement, they are likely to have a greater capacity for loss than someone who is retiring in the next 12 months.

Similarly, someone who has an annual income of £1m and monthly outgoings of £4k is going to have a higher capacity for loss than a single pensioner who has a fixed income and £50k in a building society account that is used to supplement the income and meet monthly outgoings.

In the case of the former, the investor is in a much better position to meet their liabilities (that is, their necessary day-to-day outgoings) if their investment should suffer a loss.
Other considerations might include the investor’s income stream and other assets, as these would help determine their ability to withstand loss, as well as lifestyle, which would help establish their goals, and the time horizon of the investment.

Living standard
The potential for client variation renders a standardised approach almost impossible. Given the importance of an investor’s capacity for loss, however, it might be worth identifying not only the your desired standard of living, but also your minimum acceptable standard of living.

This eases the difficult task of quantifying your “ability to absorb falls in the value of your investment”, focussing instead on your ‘risk capacity’.

Undoubtedly, a level of compromise will be required, but the process should assist you in determining capacity for loss, which could be very different from your risk appetite, and in selecting an appropriate investment.

As the investment universe becomes more complex, the necessity of selecting appropriate investments is becoming even more important.

Investment selection cannot rely solely on establishing your appetite for risk. Instead you need to take a more holistic approach, considering how much risk you can actually withstand without risk to any liabilities you may have.

Lifestyle, liabilities and time horizon are a few of the key considerations, which, if borne in mind, can help satisfy the suitability of your existing investments and any new positions you might be considering.