Here’s a riddle for you. Most casino games are skewed heavily in favor of the house, meaning that the casino gets more money the longer a game is played. However, there are a few games which, if played perfectly, give the player a slight advantage.
This makes it sound like casinos actually lose money for certain games. But this isn’t true. In general, the casino makes money even on games that favor the player. How?
Two ways. First, a lot of players don’t play these games perfectly, which hands the odds back over to the casino. But the second reason is the one I’m interested in. It’s called Risk Capacity. Simply put, the casino has more of it. Much more.
If you flip a coin a thousand times, it will be close to 50/50 between heads and tails. But in that data, there will be long streaks of heads or tails. Similarly, even in a game that favors the player there will be streaks of house wins.
If a player has enormous amounts of cash reserves, they can withstand these losing streaks. But with few exceptions, players come to the table with a fixed amount of money that pales in comparison to a casino’s reserves. Over time, a player is likely to hit a bad streak – bad enough to go bust. And at that point, it doesn’t matter what the odds were. The casino has all the money, and the player walks away empty handed.
So to restate, if both the player and casino had unlimited money to lose, over a long period of time the player would come out on top. But the player doesn’t have infinite money, and the casino has enough that it may as well be infinite. The player has less ability to lose money; they have a lower Risk Capacity.
When people think of risk in relation to investing, they usually think of Risk Tolerance. This is more of a psychological factor. A person with low risk tolerance can’t handle the roller coaster ride of stock ownership and should therefore seek lower volatility investments. When investment companies give you a short survey, they’re usually trying to figure out your Risk Tolerance. Will this person freak out and sell at a market bottom? Will they double down? These are the questions an advisor is trying to glean.
Risk Capacity is a more concrete number. To a person about to retire, they are the player, with their spending and life expectancy acting as the casino. The retiree is trying to get to the end of their life without going bust.
This is the primary reason financial advisors recommend that investors slowly buy more bonds and sell more stocks as they age. Stocks have historically provided great growth, but they have been known to dip by 30-50% in a single year. If a person who retires with one million dollars in the bank loses half of their investment in year three, they are very likely to run out of money before they die unless they severely cut back on their lifestyle. They have a low capacity for losses.
How big a dip you can survive is your risk capacity. It can even be completely opposite your risk tolerance. You can be a person with high capacity but low tolerance, or vice versa. Here are some examples:
High capacity/low tolerance – you are a person with a pension that covers all of your expenses. That means you don’t need the investment money and can therefore lose quite a bit. However, you mentally hate losing money, and it causes you to sell at all the wrong times. Therefore, you have a high Risk Capacity, but a low tolerance for loss.
Low capacity/high tolerance – you are a person who has owned stocks your whole life and never sold in a panic. You’ve watched your stocks during their worst periods and held tight. Because of this, you’ve been rewarded with great investment gains. However, you’re now at a place in life where you’re living off of your investments. That iron stomach that allowed you to weather the worst financial storms? That might be a liability at this point. Because you need this money now, and losing too much in any one year could decimate your nest egg. You need to unlearn your killer instincts and diversify, big time.
What’s the takeaway here? That your mental ability to handle losses is different from your ability to lose money without going broke. Tolerance matters more when you’re young, but capacity is paramount when you’re older. When you’re structuring your investments, you need to consider both. And if your financial advisor can’t clearly explain the difference between the two, you should find someone who can.
Disclaimer: The views expressed are for informational purposes only and are not intended to serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities by FutureAdvisor. All expressions of opinion are subject to change without notice in reaction to shifting market, economic, or political conditions. The investment strategies mentioned are not personalized to your financial circumstances or investment objectives, and differences in account size, the timing of transactions and market conditions prevailing at the time of investment may lead to different results. Clients may lose money. Past performance is not indicative of future results. Investments in securities involve the risk of loss. Any tax strategies discussed should not be interpreted as tax advice and do not represent in any manner that the tax consequences detailed will be obtained. Clients should consult with their personal tax advisors regarding the tax consequences of investing.