In short, it’s not and can’t be. Capacity for loss is independent of the tolerance to risk and is designed to understand whether your client is able to take risks. The tolerance to risk allows you to understand how tolerant your client will be about the uncertainty of the range of outcomes, whereas the capacity for loss considers their ability to maintain their standard of living if the investments change in value significantly.
The FSA’s original suitability guidance in 2011 called out as bad practice having multiple factors combined into a single score, as each client will have different weighting to each of the factors. Therefore the final risk profile should take into account the capacity for loss as well as the tolerance to risk, and be agreed upon individually with the client.
Capacity for loss is defined as the ability to maintain a standard of living. To calculate this, you need to understand the client’s outgoings and the requirement for the investment on those expenses. To do this successfully, a cash flow plan will need to be carried to show the probability that a client may have a material impact should investment returns not perform well.
In addition, there are other factors that can be considered such as dependants, potential to change income needs and the ability to change other areas of a financial plan to cope. We provide cash flow planning connected to the risk profiling of investments to give this a complete solution and our own risk profiler solutions allow additional questions to include other factors in the capacity for loss discussion.