What is the difference between risk tolerance and risk capacity?
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.
Balancing Risk Tolerance and Capacity
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, see: Risk Tolerance Only Tells Half the Story.)
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.
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®
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?
Over the last few years, advisors are starting to incorporate behavioral finance into identifying their client profiles. A person’s “risk tolerance” can give great insight into a client’s behavior as it relates to investing. A person’s “risk tolerance” would be defined as a measure of a person’s willingness to take a financial risk. But there are also 2 subsets of risk tolerance; one which is “qualitative” and helps to identify the information gathered as it relates to a client’s qualities, attitudes, and preferences (risk perception). And one which is “quantitative” and the information identified is objective and measurable (risk capacity). So for example, an individual who loves to play high stakes poker, but only makes minimum wage, would not have the same “risk capacity” as another individual who loves to play high stakes poker, but makes $5,000,000 per year.
These are two different concepts. Both are important to determine if you are on track financially and able to meet your goals. One relates to your pain threshold for investing. The other relates to whether or not you can or should take on the risk of a particular investment. Risk tolerance is emotional and is related to your state of mind. Risk capacity is a more hard-headed, black-and-white view of your financial position.
The difference between risk tolerance and risk capacity is the difference between your 'pain point' when it comes to variability in your financial position and the other is your ability to take on such risk.
Here's what I mean: Investing involves risk by its very nature. Risk can be defined in many different ways. Risk can mean the potential for loss; the potential that your principal value may be worth less than when you started out. In the Chinese language, the characters for 'risk' and 'opportunity' are the same. So, for some, when they define 'risk' 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.
For risk tolerance, the finance types use all sorts of metrics: standard deviation, beta, upside/downside ratios and more. These are a financial planner's shorthand to describe how a particular investment may be expected to vary. An investment with a standard deviation of 5% will be more stable in its value compared to one with a standard deviation of 25%. If described by a picture, the first one would be more likely a tortoise, a 'steady Eddie' type of investment. The second one would probably be pictured more like a rabbit.
Whether or not one or the other investment would be more likely to make you lose sleep at night given such expected metrics is a good idea of what risk tolerance means.
On the other hand, an investor's risk capacity has a lot to do with one's current resources and income. You need to be in a certain financial position to take on certain risks whether in life or in investing. Good measures to determine if you're in the right place would be cash flow, liquidity, debt levels, insurable risks covered and savings. In much the same way that an accountant can quantitatively determine the health of a business by running certain ratios, one can do the same for a family. So if you have little or no income or income insufficient to cover your needs, then you don't have the capacity to take on a risky action or investment. Same can be said if you don't have sufficient emergency cash reserves or debts higher than your assets or by not having sufficient life, disability or property insurance to cover an unexpected problem.
While you may have the tolerance to take on an investment with a highly uncertain or variable outcome, you may not have the financial wherewithal to pay the rent or mortgage next week. So, it wouldn't be prudent to be gambling the mortgage money for a long-shot investment regardless of how high a potential return.
Sometimes folks without much capacity for risk take a very risky course of action. Sometimes they win big and sometimes they don't. It can be a crapshoot. It's reported that the owner of FedEx early on in the company's history didn't have enough cash to cover payroll. He took the company's available cash and went to Vegas. He won big and the company had more than enough to cover its payroll so that they could live to fight another day. Now FedEx is multibillion dollar firm. Not all gambles payoff. Sometimes risk and opportunity are the same thing. Whether or not you can handle such a choice really is dependent on the situation and the alternatives.
If you need help figuring out your personal risk tolerance and risk capacity, then reach out to a Certified Financial Planner (tm) professional who can gude you through this. While there are certainly more quantitative tools out there that can help you and an advisor, aligning your risk tolerance with your risk capacity really requires a conversation.