Investment risk refers to the possibility of losing some or all of the money you have invested in a particular asset or security. The higher the risk we are willing to take, the higher the return we can expect to receive and vice versa. All investments come with some degree of risk, and the challenge is that individuals have differing attitudes toward risk, some are very tolerant, others not so much.
One thing to remember. We know the nature of the stock market is volatile. It will fluctuate up and down, and no one can predict with certainty what it’s going to do in the short run. But experts agree in the longer run stocks outperform more conservative investments and outpace the effects of inflation.
What is risk capacity?
Risk capacity is how much risk you need to take to hit a specific financial objective.
Let’s say you’re fifty years old and you want to retire around sixty-five years old. You’ve currently saved five hundred thousand. And you need to hit a certain target by the time you retire. So, you calculate the numbers and you’ve learned that you need to get a ten percent annualized rate of return to hit your desired number. Ten percent represents what you need each year to meet your objective.
Once you know that your risk capacity is ten percent. Then, it’s time to figure out your risk tolerance.
What is risk tolerance?
Investment risk is a crucial factor to consider when determining your risk tolerance, which is your ability to handle the potential losses that may result from investment decisions. Determining your personal risk tolerance is an important consideration because it helps determine what types of investments are suitable. So, if you’re a conservative person by nature, your risk tolerance in investing will likely follow suit. Thus, you may not want to be overly aggressive with stocks because it would be difficult for you to accept significant losses.
Let’s use the same scenario outlined above. You know you need a ten percent rate of return each year to hit your target. But there’s volatility in your asset allocations. So, risk tolerance is the amount you can stand to lose (and be comfortable with) within your asset allocations and still reach your objective.
Sometimes your risk tolerance and your risk capacity are the same. And, that works out well. But more often than not, they’re different. In many cases, a person’s risk tolerance is not nearly as high as the rate of return needed to reach their goal. In that scenario, they have to make adjustments, such as working longer, saving more money, downsizing or cutting back on extraneous expenses.
Why is risk tolerance important?
Risk tolerance is important because it helps determine whether or not you’ll be able to meet future financial goals in a specified timeframe given your propensity or lack thereof to take risk. For example, let’s say you’re 55 and not independently wealthy. You’re risk adverse and you want to retire in 10 years. In this case, you may need to increase your risk tolerance and become more aggressive with your investments to capture the rate of return you’ll need to retire when you’re 65.
The other alternative, if you know you can’t endure the market’s volatility, is to keep your investments the same, but push out your retirement another 5-10 years. And remember just because you may want to retire in 10 years doesn’t mean you’re going to need all of your money at that time. So, while you may pull some money out, you’ll likely leave a significant portion invested for a longer duration.
In many cases, like the one above, timeframe should be a major factor in considering your risk tolerance. The longer you have before you need access to your investments the more risk you should consider taking as this affords you the ability to ride out the ups and downs of the stocks market.
On the flip side, when you’re within a couple of years of retirement, some people choose to become less risk tolerant, as you’ll be needing some of your invested money. It would be a shame if you suffered a major loss right when you were about to retire.
What is right for you?
Many people think risk capacity and risk tolerance is the same. But, there are important differences. These concepts need to be understood before making investments. But if you understand your risk tolerance and risk capacity, it will help you make the best investments to reach your financial goals. You will be able to manage the risks that investing can bring while eliminating the stress that goes along with it.
As always, a large portion of financial decisions depend on the individual’s personal situation. And sometimes that individual may think their tolerance for risk is higher than it really is. As professional financial advisors, it’s our job to give you the best assessment of your investment risk tolerance and capacity. This helps us be able to better inform you of your best investment options.
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