Risk is an interesting concept when it comes to investing as it is dependent on the investor. Some investors feel the potential loss of investing does not outweigh the possibility of gain. For other investors, a potential of loss will sway their ability to select particular types of investments. An investor must use risk tolerance and risk capacity to determine where they fall in the realm of investing.
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. So, if you’re not one hundred percent sure about what each concept means, then you need to continue reading!
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.
Risk tolerance is how much risk you are comfortable taking before you need to throw in the towel and get out of the market.
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.
Adjustments include working a few more years, saving more money, downsizing, cutting back on a lavish lifestyle, etc.
What is right for you?
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 financial advisors, it’s our job to dig in and really understand each person’s financial situation and their personalities so we can advise them.
For example, if someone takes on more risk than they can tolerate, chances are they’ll end up making bad financial decisions. They’ll leave the market at the worst possible time (like a major downturn.) The person would be better off being more conservative (and taking less risk) in their investment portfolio. That way, they can stay the course during a market downturn like what happened in 2009.
It’s also within this scenario where the adjustments we discussed previously come into play. By deciding to work a few extra years or downsizing, an individual can be more conservative with their investments and be able to ride out a downturn in the market (rather than pulling the trigger and selling everything off.)
Understanding your risk tolerance and risk capacity 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. A professional financial advisor can give you the best assessment of your risk tolerance and capacity and will also be able to better inform you of your best investment options.
It’s important you understand the difference between risk capacity and risk tolerance. Listen to our podcast for more information.