Risk Capacity vs. Risk Tolerance
In this article: Two important aspects of financial planning. By understanding the difference, you can plan your finances accordingly.
Published Mar. 20, 2018
Reading Time: 3 minutes.
Regardless of if your a long-time investor, or just dabbling in the markets, evaluating your risk capacity and risk tolerance is critical for the health of your investments. Risk capacity and risk tolerance impact how you invest, what financial products you invest in, and help evaluate the time frames and expectations when it comes to achieving your investment goals.
What is Risk Capacity?
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. Think of it as the 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. With this in mind, you’d select investments that account for the capacity of risk you can take.
Picture this: If you had half of your retirement account invested in small-cap stocks and 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.
What is Risk Tolerance?
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 emotions and personal feelings around your investments, 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, imagine 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 they may not affect your financial goals to the same degree. While changes in the stock prices might not affect your risk capacity, they’ll leave you with a wry taste in your mouth – a clear indicator that it’s 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 can comfortably add higher-risk products to your investments.
What to Consider When Investing: Risk Tolerance vs Risk Capacity
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. Evaluating risk is particularly critical during the growth stage of your retirement plan.
Through effective risk management guided by a top financial advisor, 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.