Investment strategy: What is my risk capacity?

According to the last Economico Flash, your risk capacity and your risk appetite are the two key parameters for determining your risk profile and thus the target range of your personal investment strategy. You need economics to determine your objective risk capacity and psychology to determine your risk appetite. We believe that the financial and advisory industry should focus primarily on the former and leave the assessment of personal risk appetite to the client and investor (or their psychologist).

The exact measurement of a private investor's risk capacity requires the modelling (as accurately as possible) of all future personal income or expenditure as well as all assets and liabilities. In this context we use the term asset-liability management (ALM) for private investors. This can be done, but it is rather complex and subject to considerable forecasting uncertainty.

For people who are beginning to think about retirement, however, risk capacity can be approximated using a relatively simple indicator. First, the so-called coverage gap is calculated as the difference between income (after retirement) and planned expenses (also after retirement). For unforeseen expenses, a safety margin is added to the expenses – the 20% used in the illustration is more gut feeling than science. The assets at retirement (including capital withdrawals from the second and third pillars) are then compared with this coverage gap including the safety margin.

The interpretation of this indicator is straightforward: for how many years will the accumulated assets at retirement be sufficient to finance the coverage gap? If the value exceeds 45 years, we consider your risk capacity to be high and therefore an investment strategy with a focus on real assets and equities to be reasonable. If, however, your assets would already be exhausted after 15 years of retirement, you can hardly afford losses on the capital markets and are better served with low-risk, fixed-income investments.

On Economico we have provided a simple risk-profiling function that can support you in determining your investment strategy.