Capacity, willingness and requirement: the three sides of risk

Most risk questionnaires measure one side of risk: how you feel about losses. There are three sides, and a portfolio has to satisfy all of them.

The mistake

Taking risk because a questionnaire said you could stomach it, or because a higher yield looked attractive, without checking whether your finances can absorb it or your goals need it.

The evidence

From 3 January to 12 October 2022, the S&P 500 fell 25.4% (Yardeni Research). A $1,000,000 stock portfolio tracking the index would have lost about $254,000 on paper. The useful question is not whether you could tolerate 25% in the abstract. It is what you would have done with $254,000 gone.

The three sides

Capacity: how much loss your finances can absorb. It depends on your time horizon, how stable your income is, your other assets and when you will need cash. A scientist whose salary, bonus and stock awards all come from one employer has less capacity than the balance suggests: one bad trial readout can hit the job and the portfolio at the same time.

Willingness: how much decline you can live through without selling. Measure it in dollars, not percentages, and against a real episode such as 2022.

Requirement: how much risk your goals need. It comes from your plan: the return your goals require in the base case. If your goals can be met with less risk, there is no reward for taking more.

When the three disagree

What you find	What it usually means
Willingness is higher than capacity	Capacity sets the limit. Feeling comfortable does not make a loss affordable.
Capacity is higher than willingness	Take the lower level, or the portfolio is likely to be abandoned in the next decline.
Requirement is higher than both	Change the plan, not the risk: save more, extend the timeline or adjust the goal.
Requirement is lower than both	You can take less risk than you are able to.

Three ways to handle a risk

Once a risk is identified, there are three responses.

• Avoid it: don’t take it at all. For example, keep money you will need in the next few years out of stocks.
• Reduce it: diversify, sell down a concentrated position on a schedule, size positions deliberately, rebalance.
• Transfer it: move it to someone paid to carry it, such as an insurer for disability, life or liability risk.

A note on chasing yield

A higher yield is usually payment for a risk: lending to weaker borrowers (credit), tying money up for longer (duration), holding assets that are hard to sell (liquidity), or borrowing to invest (leverage). Before reaching for yield, name the risk you are being paid to take and check it against all three sides. For one example, see Structural Vulnerabilities in the US Treasuries & Private Credit.

The tool: a three-sides self-check

Side	Question	Your answer
Capacity	If your portfolio fell 25% next year, would any goal in the next five years be at risk?
Capacity	How much of your income and your portfolio depends on one employer?
Willingness	What would a 25% fall cost you today, in dollars? What would you do?
Requirement	What return does your base case need to meet your goals?

Then, for each risk you find, choose a response:

Risk	Avoid	Reduce	Transfer
Concentrated employer stock
Losing income to disability
A market fall just before a near-term goal
Your own:

How this is handled in practice

Every portfolio starts by measuring all three sides of risk: capacity, willingness and requirement. Each risk we find is then given one of three responses: avoid it, reduce it or transfer it. Investment management is offered through Gwynedd Wealth Partners, LLC.