What is the difference between risk tolerance and risk capacity?

By Ayton MacEachern AAA
A:

Risk tolerance and risk capacity are two concepts that need to be understood clearly before making investment decisions for yourself or for a client. Together, the two help to determine the amount of risk that should be taken in a portfolio of investments.

Risk Tolerance
Risk tolerance is the amount of risk that an investor is comfortable taking, or the degree of uncertainty that an investor is able to 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
Risk capacity, unlike tolerance, is the amount of risk that the investor "must" take in order to reach financial goals. The rate of return necessary to reach these goals can be estimated by examining time frames and income requirements. Then, rate of return information can be used to help the investor decide upon the types of investments to engage in and, the level of risk to take on.

Income targets must first be calculated in order to decide the amount of risk that may be required. (To learn more, read the related article Determining Your Post-Work Income.)

Balance of Risk
The problem many investors face is that their risk tolerance and risk capacity are not the same. When the amount of necessary risk exceeds the level the investor is comfortable taking, a shortfall most often will occur when it comes to reaching future goals. On the other hand, when risk tolerance is higher than necessary, undue risk may be taken by the individual. Investors such as these sometimes are referred to as risk lovers.

Taking the time to understand your personal risk situation may require self-discovery on your part, along with some financial planning. While attaining your personal and financial goals is possible, reason and judgment can be clouded when personal feelings are left unchecked. Therefore, working with a professional may be helpful. (For related reading, be sure to check out Risk Tolerance Only Tells Half The Story.)

This question was answered by Ayton MacEachern.

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