Risk capacity and risk tolerance are very important factors in a sound financial plan. They impact how you invest, what financial products you invest in, and time frames and expectations when it comes to achieving your goals.
In this piece, we will discuss each, along with the relationship between the two, and how to use risk as a tool for financial planning success.
Risk capacity is a mathematical measure of how much risk you can take before it affects your financial goals. This risk normally takes the form of volatility and potential losses. In assessing your risk capacity, you should look at both the probability of your investments turning negative and the possible losses that might come about, particularly in proportion to your other assets and their risk levels.
Risk capacity is normally calculated during a risk analysis process, and, in its simplest form, it is a dollar value of the amount of risk exposure you can take.
During a risk analysis, you may agree that you have a risk capacity of $50,000 for your portfolio. Any changes to the stock prices in excess of $50,000 loss in value, would exceed your risk capacity. You would, therefore, select your investments with this in mind.
If, for example, you had half of your retirement account invested in small-cap stocks, the other half invested in one large-cap stock, any major drops in the one large-cap stock price would affect the portfolio as a whole considerably. As you approach your risk capacity, you may consider adjusting your portfolio.
In contrast, your risk tolerance is your ability to handle volatility and potential losses on your investments. Your risk tolerance is essentially based on your personal feelings and tastes, rather than an objective mathematical measure in relation to your financial goals.
In assessing your risk tolerance, you should imagine how much angst and stress you can manage in comparison to the potential gains. If the stress of losses or volatility is too much for you to bear, you may wish to invest in less risky, less volatile assets.
For example, assume you have a small portfolio of stocks in addition to a pension and larger basket of secure financial products for retirement. Extreme downturns in your stocks may create a difficult emotional situation for you – although may not affect your financial goals to the same degree. Changes in the stock prices may not affect your risk capacity but could be unsatisfactory for your risk tolerance.
Risk tolerance works in the other direction as well. If you find that you are comfortable with increased volatility and can emotionally handle the risk of potential losses, you may wish to add higher-risk products to your investments.
In determining your financial goals it is essential to determine your risk capacity and risk tolerance, as well as understand the difference between the two.
Both risk capacity and risk tolerance are essential to setting and achieving your financial goals, as they are an important factor in guiding what kinds of investments you should invest in.
Through effective risk management, you can prevent unwanted surprises in your investing and financial planning as well as feel greater comfort in the process of reaching your financial goals.