Risk tolerance and risk capacity are two concepts that must be clearly understood before making investment decisions. Together, the two help determine the amount of risk to take in an investment portfolio. That risk determination is combined with a target rate of return (or how much money you want your investments to make) to help build an investment or asset allocation plan.
Risk ability and risk tolerance may seem similar, but they are not the same.
Personal risk tolerance is the amount of risk that an investor is comfortable taking or the degree of uncertainty that an investor can handle. Risk tolerance often varies with age, income, and financial goals. It can be determined by many methods, including questionnaires designed to reveal the level at which an investor can invest but still be able to sleep at night.
Risk capacity, as opposed to tolerance, is the amount of risk that the investor “must” take to achieve his financial goals. The rate of return required to achieve these goals can be estimated by examining timeframes and income requirements. The information on the rate of return can then be used to help the investor decide on the types of investments to make and the level of risk to take.
Income targets must first be calculated to decide the amount of risk that may be required.
- Risk ability and risk tolerance work together to determine the amount of risk assumed in an investor’s personal portfolio.
- Risk ability often has to do with an investor’s income and financial resources.
- Risk tolerance generally depends on many factors, including financial plans for the future, income, job, and age.
The problem many investors face is that their tolerance for risk and their risk capacity are not the same. When the amount of risk required exceeds the level the investor is comfortable assuming, a shortfall will most of the time occur in terms of achieving future goals. On the other hand, when risk tolerance is higher than necessary, the individual may take undue risk. Investors like these are sometimes called risk lovers.
Taking the time to understand your personal risk situation may require some self-discovery on your part, along with a bit of financial planning. While it is possible to achieve your personal and financial goals, reason and judgment can be clouded when personal feelings are not controlled. Therefore, working with a professional can be helpful.
Steve Stanganelli, CFP®, CRPC®, AEP®, CCFS
Clear View Wealth Advisors, LLC, Amesbury, MA
Risk can be defined in many different ways. For some, it is not the potential loss of one’s equity that is as important as the possibility of losing profit to the upside by not acting in a certain way or investing in a certain asset.
Finance types use all kinds of metrics for risk tolerance: standard deviation, up / down ratios, etc. They describe how an investment can be expected to vary. Whether or not one investment is more likely to make you lose sleep at night than another is a good idea of what risk tolerance means.
The riskiness of an investor has a lot to do with resources and income. You must be in a certain financial position to take certain risks. The measures to determine risk capacity are cash flow, liquidity, debt levels, insurable risks covered and savings.