What is the difference between risk tolerance and risk capacity?

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November 2016
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That’s an interesting question and it depends on who you ask. I will answer with a focus on losses rather than gains because, for most people, risk implies the chance that they will lose money rather than make money.

In my view, risk tolerance is your emotional capacity to withstand losses without panicking. As an example, during the financial crisis of 2008/2009, people with a low or modest risk tolerance, who saw their investment portfolios decline by as much as 50% because they were heavily invested in stocks, sold out and did not recoup their losses when the stock market began its recovery. Their risk tolerance was not aligned with the risk they were taking in their portfolio.

Risk capacity, on the other hand, is your ability to absorb losses without affecting your lifestyle. The wealthy have the capacity to lose thousands, millions, or even billions of dollars. Jeff Bezos, founder of Amazon, recently lost $6 billion dollars in a few hours when his company’s stock dropped dramatically, leaving him with a net worth over $56 billion. His risk capacity is orders of magnitudes greater than most people’s net worth. 

There are some new tools available to measure your risk tolerance and determines how well your portfolio is aligned with your risk number.

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