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. That risk determination is combined with target rate or return (or how much money you want your investments to earn) to help construct an investment plan or asset allocation.
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 the 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.
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 in terms of reaching future goals. On the other hand, when risk tolerance is higher than necessary, the 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.
Steve Stanganelli, CFP®, CRPC®, AEP®, CCFS
Clear View Wealth Advisors, LLC, Amesbury, MA
Risk can be defined in many different ways. For some, it's not the potential loss of one's principal that is important as much as the prospect of losing out on the upside gain by not acting in a certain way or investing in a certain asset.
Finance types use all sorts of metrics for risk tolerance: standard deviation, upside/downside ratios, etc. They describe how an investment may be expected to vary. Whether or not an investment would be more likely to make you lose sleep at night than another is a good idea of what risk tolerance means.
An investor's risk capacity has a lot to do with resources and income. You need to be in a certain financial position to take on certain risks. Measures to determine risk capacity are cash flow, liquidity, debt levels, insurable risks covered and savings.