Risk Capacity vs. Risk Tolerance
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Two important aspects of financial planning are risk tolerance and risk capacity. Understanding the difference between the two can help you plan your finances more efficiently.
Whether you’re a long-time investor or just starting to dabble in the markets, evaluating your risk capacity and tolerance is critical for the health of your investments. These concepts influence how you invest and the financial products you choose, and they help you evaluate the timeframes and expectations for achieving your investment goals.
What is Risk Capacity?
Risk capacity refers to the quantitative measure of how much risk you can take before it affects your financial goals. This risk typically takes the form of volatility and potential losses. When assessing your risk capacity, consider both the likelihood of your investments declining in value and the possible losses, particularly in relation to your other assets and their risk levels.
Risk capacity is usually calculated during a risk analysis process. Think of it as the maximum dollar amount of risk exposure you can take. For example, that your risk capacity for your portfolio is $50,000 any loss exceeding this amount would surpass your risk capacity. Therefore, you’d select investments that account for the capacity of risk you can take.
Picture this: If half of your retirement account is invested in small-cap stocks and the other half in a single large-cap stock, a major drop in the price of that large-cap stock could significantly impact your entire portfolio. As you approach your risk capacity, you may want to adjust your portfolio accordingly.
What is Risk Tolerance?
In contrast, risk tolerance is your ability to handle the emotional aspects of volatility and potential losses. Unlike risk capacity, which is an objective measure, risk tolerance is subjective and based on your personal feelings regarding your investments.
When assessing your risk tolerance, consider how much stress and anxiety you can manage compared to the potential gains. If the stress of market fluctuations is overwhelming, you may prefer to invest in less risky, more stable assets.
For example, if you have a small portfolio of stocks in addition to a pension and a larger basket of secure financial products for retirement, extreme downturns in your stocks could create emotional strain, even if they don’t significantly affect your overall financial goals. While fluctuations in stock prices might not impact your risk capacity, they can leave you feeling uneasy—an indication that your investments exceed your risk tolerance.
Conversely, if you find that you are comfortable with higher volatility and can emotionally handle the risk of potential losses, you might consider adding higher-risk products to your portfolio.
What to Consider When Investing: Risk Tolerance vs Risk Capacity
Determining your financial goals requires an understanding of both your risk capacity and risk tolerance. Both factors are essential in guiding the types of investments you should consider. Evaluating risk is particularly critical during the growth stage of your retirement plan.
Through effective risk management guided by a fiduciary financial advisor, you can mitigate unwanted surprises in your investment and financial strategy and enhance your comfort towards reaching your financial goals.
Disclosure: This material provided by Zoe Financial is for informational purposes only. It is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy, or investment product. Nothing in these materials is intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Zoe Financial is not an accounting firm – clients and prospective clients should consult with their tax professional regarding their specific tax situation. Opinions expressed by Zoe Financial are based on economic or market conditions at the time this material was written. Economies and markets fluctuate. Actual economic or market events may turn out differently than anticipated. Facts presented have been obtained from sources believed to be reliable. Zoe Financial, however, cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Zoe Financial does not provide legal advice.