You need to understand your willingness, need, and ability to take portfolio risks. It’s an idea that straddles the line between personal preference and objective truth.

Let’s break down each of the three constituents, then put it all together with an example.

Need

Your need to take risks relates to the amount of objective investment growth required to meet your financial goals.

Understanding need starts with a comprehensive financial plan showing your projected cash flow over the next 10 or 20 years. Money in, money out, and most pertinent to today’s topic, your projected portfolio withdrawals. Those future portfolio withdrawals dictate your need for risk today.

For example: I’d argue that reader Vince (the star of Winning the Game: Retiring at 57 with $4.2M) had minor needs for investment risk. His asset base is very healthy, his withdrawals are proportionally small, and therefore, little risk is needed for Vince to meet his goals.

Whereas a family underfunded for their Retirement goals might have either 1) an enormous need for investment risk or 2) the need to decrease their financial goals.

Need is about how much investment growth you require.

Ability

Ability is related to need, albeit on the opposite side of the coin. An investor’s ability to take risk is based on their capacity to withstand or recover from losses (either temporary or permanent). Need is a function of required growth, ability is a function of recovery from loss.

In general, the more assets you have, the greater your capacity to recover from loss. More assets = more ability for risk. That’s why certain high-risk, concentrated, and/or illiquid assets are only appropriate for investors with “excess capital.” Those investors are the only ones with the ability to take on that risk.

But for younger or newer investors, the ability to take on risk is directly proportional to their income and savings rate. They have long timelines of dollar cost averaging ahead of them. They have decades to make up for any losses. Their ability for risk is high.

Ability is about recovering from loss, either through excess current assets or a healthy stream of future saving.

Willingness

Willingness is the only subjective measure in today’s trio. It’s purely mental. How will you react to the higher volatility that comes with high-risk investments? Are you willing to stomach losses?

Willingness is not correlated with need or ability. That fact complicates the act of giving responsible financial advice. If someone’s need suggests large returns but their willingness cannot stomach any risk, how do we square that circle?

Willingness is the “personal” side of this personal Finance topic. Need and Ability are both objective. Willingness is subjective. Each of your Willingness’s will be unique and different.

Putting It All Together

How do we combine these three factors to provide actual portfolio advice?

When I give advice, I do my best to collect both objective data and subjective feelings.

The objective data helps my colleagues and me assess Need and Ability. Based on those numbers, we can provide a range of portfolio allocations that should work well for the particular investor. e.g. “from 60% to 75% stocks, plus 35% to 15% bonds, plus 0% to 10% alternatives or private investments.”

This objective portfolio range can then be combined with the investor’s subjective Willingness for risk. If they’ve voiced their opinion for high-octane risk-taking, we’ll advise them toward the aggressive end of our range. The more timid investor will be advised toward the conservative end of the range. Either way, we feel comfortable that the objective numbers will work out in their favor.

But what if someone pushes back further, showing a Willingness outside our prescribed asset allocation range? There are a few outcomes from here:

1. Sometimes, we worry that a client’s hard-headedness prevents us from providing fiduciary advice. For example, one client insisted on selling to cash during the spring of 2020 (peak COVID-19 fright in the markets) and then insisted upon staying in cash. The lost all Willingness for risk. They ignored our cautions against this move. They ended up unhappy with their results, and we were unhappy they ignored us.
2. If a client only wants to push slightly outside our recommended range, we have a transparent and reasonable conversation. For example, an aggressive investor client asked to be invested in 100% equities despite our “max risk” recommendation of 80% stocks, 10% bonds, and 10% alternatives. That’s what their Need and Ability suggested. We discussed the pros and cons of our recommendation compared to their preference. We all understood each other, and ultimately invested their money in our stock portfolio per their preferred allocation – 100% stocks. We don’t want to make perfect the enemy of good enough.
3. If a client is more conservative than we recommend, that typically warrants a different conversation: you might not hit your stated goals on time. In that case, our recommendation is often based on their Need for long-term growth in order to fund retirement, afford the kids’ college, buy their dream lake house, etc. But if their Willingness is conservative, then their preferred portfolio likely won’t grow fast enough. Again, we hold an open and honest conversation; each conversation feels and sounds different.

The triad of Need, Ability, and Willingness isn’t perfect. But it’s a darn good start. Combining the objective and subjective reasons for risk and reward is a terrific framework for portfolio construction.

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-Jesse

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Jesse Cramer Writer & Financial Planner

Jesse Cramer is the writer of The Best Interest blog, the voice behind The Best Interest Podcast, and works full-time as a fiduciary financial planner for Cobblestone Capital Advisors in Rochester, NY.