What is the difference between risk tolerance and risk capacity?
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.
Your ability to tolerate risk, personally, is your risk tolerance. For example, would you be okay with extreme volatility in your portfolio, if it was for the sake of greater long-term returns? Some people would agree with this statement; their risk tolerance is relatively great. However others might disagree, and say they would prefer stability, even if it meant lower returns; their risk tolerance is relatively low.
Risk capacity is a function of your actual ability to take risk. Someone who is several decades away from retirement has a greater risk capacity than someone who is only a couple of years from retirement. Someone who has a high net worth has a greater risk capacity than someone with very limited funds. Risk capacity has to do with the amount of risk you can afford to take; would a 20% market downturn affect you dramatically? Or do you have enough funds that you could survive such a dip? Or, do you have enough time to recover from such a dip, before you'll need to access the funds?
Risk tolerance is a Behavioral Finance term used to describe how much volatility you can tolerate. Risk Capacity is how much risk you can actually and realistically handle without causing a significant negative change in lifestyle.
Best of luck, Dan Stewart CFA®
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 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, 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.
The Investopedia answer is spot on, providing an excellent definition and explanation to both of these concepts. I’d like to add a few personal thoughts about risk tolerance, especially in view of the fact that the stock market has been on an upward trend for the past 5 years. For most of us with money in mutual funds, ETFs, or other diversified investments, it’s been a pretty sweet half decade. When things are going good, it’s easy to begin to think of yourself as very risk tolerant. It’s so nice to glance at your statements and see green designating that you have more money than you had last month or last quarter. However, if you are old enough to remember 2008 and other historical periods when the stock market (and our mutual funds!) lost value, you may want to think about revising your outlook on risk. It doesn’t mean that you should necessarily sell your investments or stop investing, but you want to be aware of the risk each of your investments entails to make sure that you are knowledgeable about, and comfortable with, those risk levels. The question really comes down to the question of whether you can stomach losses – including possible loss of principal – in your quest for gains. As Investopedia’s Ayton MacEachern wisely writes, “taking the time to understand your personal risk situation may require self-discovery on your part, along with some financial planning.” Thanks so much for writing!