What’s the Difference? Risk Capacity vs. Risk Tolerance
Lisa Whitley — As our final installment in this short series of articles, we’ll wrap up exploring the differences between common financial vehicles. Maybe you know already, perhaps you don’t; either way a rising tide lifts all boats!
What is the difference between risk capacity and risk tolerance?
The very first question that you will encounter as an investor is “How much risk should I take?” This answer, as you might imagine, is “it depends.” But what does it depend on?
First, consider how long you plan to invest. For example, if you are young and investing for retirement, your timeline may be quite long; you may not need these funds for 30 or more years. You have the capacity to take on more risk in your investment portfolio because, over the span of 30 years, you can comfortably ride out changes in the market.
You can…but will you want to? Many people, regardless of their age, simply are uncomfortable when they see the value of their investment fluctuate. More specifically, they are uncomfortable when they see the value fall. As a result, they are likely to sell their investment at the first sign of market turmoil even though they may actually have the capacity to withstand the storm. In this case, the investor has a low tolerance for risk. That is neither good or bad; it’s just how they are built. Reflect back on a day when the media reported that the stock market had dropped precipitously. Did you feel panicked? Did you want to invest even more? Did you even notice? How you answer these questions will give you insight into your personal risk tolerance.
Investing is the art of balancing two factors:
- Understanding objectively what your capacity is to take on risk, based on your time horizon.
- More subjectively, understanding what kind of an investor you are and how you are likely to react in both good times and bad.
Always bear in mind that risk capacity and risk tolerance are personal and change over time; no one can tell you what your capacity and tolerance “should” be.