What is ‘capacity for loss’?

When making an investment decision, one question must be asked from the outset: how much can you afford to lose? The answer captures what is known among financial planners as your ‘capacity for loss’ and should shape your investment approach.

You may have a clear idea of how much you would like to gain from your investments, but you may be unsure of your financial ability to shoulder potential losses. In this article I explain what capacity for loss means, how it can be calculated and its role in holistic financial planning.

Capacity for loss refers to someone’s financial ability to endure potential losses to their investments without a significant impact on their financial stability or lifestyle. Unlike risk appetite, which refers to an individual’s psychological willingness to hold higher or lower risk investments, capacity for loss is a practical measure. It assesses whether someone can afford the potential consequences of investment choices they are considering.

Appetite for risk

For example, someone may have a very high appetite for taking on risk but a low capacity for actual losses. This person may desire riskier investment opportunities, hoping for high returns. But they should consider how potential losses from higher risk investments could affect their more limited financial resources.

Conversely, someone else may have a very low appetite for taking on risk despite having ample financial resources and living quite frugally. They may want to consider making their money potentially work harder for them by taking on more investment risk.

Finally, some people correctly align their risk appetite with their capacity for loss. This leads to a balanced investment approach that takes into account individual financial circumstances and goals.

Cash flow modelling

Assessing capacity for loss can be challenging, as we often overestimate or underestimate our financial resilience. So it is important to use professional tools such as cash flow modelling to help gain an accurate understanding of your capacity for loss. This can help ensure our investment decisions truly align with our financial circumstances.

At Schroders Personal Wealth (SPW) we advocate holistic financial planning. So we consider all aspects of your personal and financial life as we strive to safeguard your financial future. This means our assessment of your capacity for loss incorporates both your current financial circumstances and how your needs may change over time.

We rely on cash flow modelling to evaluate your capacity for loss. These models provide in-depth financial projections, outlining different scenarios to ensure you have a clear understanding of the potential consequences of your investment decisions. Each SPW cash flow model includes a provision for the potential costs of care in old age, to ensure every plan is built for the long term.

Scenario analysis

Cash flow modelling begins by establishing a base plan that reflects your current financial situation and goals, including your assets, income and living expenses. We then explore various scenarios, such as a market downturn or a shift in investment strategy, to illustrate their potential impact on your financial wellbeing. By comparing these scenarios, you can visualise your capacity for loss in a tangible way, allowing you to discover an investment approach that aligns with your goals and circumstances.

At SPW, we focus on capacity to give away as well as capacity for loss, acknowledging that many clients wish to gift assets to charity or loved ones. This approach could allow you to support causes you care about or provide for children or grandchildren, fostering a sense of fulfilment without compromising your financial stability.

In the end, you need to consider capacity for loss when crafting a financial plan that aligns with your personal goals and accounts for your long-term financial security. This can help you make confident investment decisions, embracing opportunities for growth while guarding against risks to your financial wellbeing.