There is no single piece of investment advice that applies to every individual investor. What’s best is often based on risk tolerance and risk capacity. In this blog, La Ferla Group breaks down the differences and similarities between the two, as well as a few ways to deal with risk in investing.
Risk Tolerance vs. Risk Capacity
What is Risk?
Before defining risk tolerance and risk capacity, it’s necessary to understand what we mean by “risk” when referring to investing.
Risk is the chance that an investment’s actual return will differ from its expected return. In other words, risk refers to an investment’s potential loss. Some investment vehicles fluctuate than others. The more volatile an investment is, the higher risk associated with it.
What is Risk Tolerance?
Risk tolerance is the degree of risk that an investor is willing to withstand. The word “willing” implies emotion here.
New investors rarely consider the role of emotion. Investors who panic and sell off assets as soon as their price fluctuates may miss out on a potentially large return.
What is Risk Capacity?
Risk capacity, on the other hand, is strictly financial. It refers to how much a market downturn would possibly affect one’s financial goals. In other words, risk capacity is about how much risk one is financially able to bear.
How do the Two Intersect?
Some investors may encounter that their risk tolerance and risk capacity is the same. The risk necessary to meet one’s financial goals may exceed their risk tolerance, which could possibly result in a shortfall. Conversely, one’s risk tolerance may be unusually high, resulting in unnecessary risk being undertaken.
3 Factors that Affect Risk Tolerance and Capacity
There is no set formula to simply calculate risk tolerance or capacity. They are subjective to one’s financial situation, and we highly recommend seeking the help of a Certified Financial Planner™. However, these three factors are common ones to consider.
1. Risk Capital
Risk capital, or the money an investor is reasonably able to invest, is a main component that affects both capacity and tolerance. Relatively wealthy investors may feel more comfortable undertaking a larger amount of risk, since the consequences of losing money are less severe.
2. Investment Experience
Most investments do not constantly increase in value. Even safe investments with upward trends see dips in value, some more than others. Experienced investors know this, and are often less likely to panic during market fluctuations than new investors.
3. Investment Objectives
Although they tend to have less financial resources, young people at the beginning stages of their careers often have higher risk capacities. That’s because they have a large window of time to build wealth before retirement. One individual year’s loss is not as devastating to them.
Older investors, however, tend to have relatively lower risk capacities since the main objective of their investments is most likely to build wealth quickly. They don’t have as much time to recover from a financial loss.
How to Manage Risk
Risk is often managed by spreading funds across several different asset classes. The recommended asset classes will differ based on one’s own risk tolerance and capacity, since asset classes can have different levels of volatility:
- Equities or stocks have medium to high volatility
- Fixed income or bonds have low volatility
- Cash equivalents or money market instruments have low volatility
One’s risk is effectively lowered by allocating funds across these different types of investment vehicles.
Remember to always consult with a Certified Financial Planner™ before investing, so your risk can be managed properly.