Whether you’re new on the investment scene or an old hat looking to refine your strategy, accurately determining your risk profile requires knowing both your risk tolerance and risk capacity. A two-dimensional approach to risk tolerance involves assessing how much risk you’re willing to take and how much risk you can afford to take. Often confused, these two factors are distinct and essential to creating a balanced investment plan.
Sound investment recommendations require thoughtful evaluation and equal consideration of both risk tolerance and risk capacity. In this article, we explain the key differences between them and how they work together to determine a more precise risk profile.
Getting Started Risk Tolerance & Risk Capacity
What's the difference between risk tolerance and risk capacity?
Risk tolerance is an inherently subjective measure of your emotional ability to tolerate market volatility.
Risk capacity is measured by objective factors like income, assets, liabilities, time horizon, and financial obligations.
What are the dangers of not understanding my risk profile?
Risk tolerance and capacity are very distinct concepts. Traditional risk assessments can lead to misleading conclusions as they tend to consider one or the other, or conflate the two.
Without full consideration of both, you risk receiving investment recommendations that don’t fully align with both your personal nature and your financial situation.
Risk Tolerance vs. Risk Capacity
Defining Risk Tolerance
Risk tolerance refers to your willingness and ability to endure the swings of the market. Your temperament and emotional response to loss help determine your tolerance for risk.
Two investors with identical financial situations might have very different reactions to the same market downturn. One might stay calm and stick to their plan, while the other might panic and sell off assets.
Defining Risk Capacity
Risk capacity is your financial ability to absorb losses. It evaluates how much risk you can afford to take without jeopardizing your current assets and financial goals. Factors that help determine risk capacity are income, job stability, time horizon to retirement, and overall financial situation.
An investor with a stable, high income and significant savings can likely afford to take on more risk compared to someone with high debt and a lower or less stable income.
The Key Differences Between Risk Tolerance and Risk Capacity
Risk tolerance and capacity are very distinct concepts. Traditional risk assessments can lead to misleading conclusions because they often fail to capture the full picture. Without equal consideration of both capacity and tolerance, investment recommendations won’t fully align with both your personal nature and your financial situation.
- Risk tolerance is a subjective measure of your emotional ability to tolerate market volatility. The willingness to tolerate risk is influenced by temperament, past investment experiences, and the current financial news cycle.
- Risk capacity is measured by objective factors like income, assets, liabilities, time horizon, and financial obligations.
Assess Risk: Real Life Example
To illustrate the concept of risk tolerance vs. risk capacity, let’s consider an investor who we’ll call Colin.
Colin is a young professional with a well-paying, stable job, and retirement is still in his distant future. He is new to investing, with the bulk of his investments tied up in his 401(k), which he diligently contributes to. Colin’s cash savings are minimal at present, and he is still paying off student debt.
Market fluctuations fluster Colin. The pressure causes him to second guess his decisions and he begins to question whether he should adjust his investments. This is a clear indication that his tolerance for risk is low, a condition known commonly as risk-averse.
A traditional risk assessment might give Colin a median score, suggesting a balanced or moderate growth portfolio based solely on his long time horizon and low risk tolerance.
A two-dimensional approach changes the recommendations for Colin significantly. Due to his solid, steady income and decades until he accesses his 401(k), his risk capacity is pretty high. However, when we account for Colin’s student loans and insignificant cash savings, as well as his goals of purchasing a home and a new car, his risk capacity drops. As a novice investor with a low tolerance for risk, he prefers stability.
A moderately aggressive portfolio suits Colin’s 401(k), balancing potential growth with his comfort level by starting moderately rather than aggressively. A conservative approach is recommended for Colin’s non-retirement assets, ensuring that funds needed for short-term goals are protected from significant market volatility.
Just as people evolve over time, so do market conditions, personal circumstances, and financial goals. Ongoing reviews and adjustments to Colin’s financial strategy are important to maintaining a successful financial plan.
The Importance of Risk Tolerance & A Comprehensive Financial Plan
Shaping an effective investment strategy hinges on a thorough understanding of your risk tolerance. It reflects how comfortable you are with market ups and downs and potential losses.
A comprehensive financial plan focuses on your specific goals and helps determine how much risk you can realistically afford. By evaluating your income, assets, liabilities, and time horizon, your financial plan provides the context needed to balance potential gains with acceptable risk.
Your financial goals and time horizon play a crucial role in this. Short-term goals often require a more conservative approach to investing. Given the time available to recover from market fluctuations, long-term goals allow room for higher risk.
Your financial advisor can work with you to create a plan tailored to you. Regularly reviewing and adjusting your strategy based on your evolving circumstances and objectives will keep you on track to achieve your financial goals.
How To Determine Your Risk Tolerance
- Fill out a risk assessment questionnaire.
- These questionnaires may ask about your age, your income, and how much wealth you have.
- They may include hypothetical questions like, “If you had a million dollars and it suddenly dropped to $700,000, what would you do? Would you stay calm and ride it out, start to sell off in a moment of panic, or perhaps buy more?”
- Ask yourself:
- What are my investment goals?
- When do I need the money and what do I need it for?
- How would I react if my portfolio lost 20-30% in just one year?
Risk Profiles
Risk profiles range from very conservative to very aggressive, each reflecting different levels of risk tolerance and potential returns. Here’s a breakdown of the various risk profiles to help you understand where you might fit:
- Very Conservative:
- Prioritizes capital preservation over returns.
- Invests primarily in low-risk assets such as bonds, Treasury bills, and cash equivalents.
- Suitable for short-term goals or those with a low tolerance for market volatility.
- Emphasizes stability and minimizes potential losses.
- Conservative:
- Focuses on steady, low-risk investments with modest returns.
- Includes a mix of bonds and a small percentage of equities.
- Aims to protect principal while seeking moderate growth.
- Suitable for those who can tolerate limited market fluctuations but prefer safety.
- Moderate:
- Balances risk and return by diversifying across various asset classes.
- Typically includes a balanced mix of equities, bonds, and possibly other assets.
- Aims for moderate growth while managing risk.
- Suitable for those with a balanced approach to risk and return, often with a medium-term investment horizon.
- Aggressive:
- Seeks higher returns by taking on more risk.
- Primarily invests in equities and may include higher-risk assets like international stocks or commodities.
- Accepts significant market volatility in pursuit of higher long-term growth.
- Suitable for those with a high risk tolerance and a longer investment horizon.
- Very Aggressive:
- Maximizes potential returns by accepting substantial risk.
- Focuses heavily on equities, including volatile or speculative investments.
- Experiences significant market fluctuations and potential for large gains or losses.
- Suitable for those with a very high risk tolerance and a long-term investment horizon, willing to endure considerable volatility for the chance of higher returns.
Practical Tips for Investors
- Know your risk profile.
-
- Understand your own risk tolerance and risk capacity.
- Use risk assessment questionnaires to identify your risk profile.
- Regularly review and update your risk profile as your financial situation and market conditions change.
- Understand your financial goals and time horizon.
-
- Clearly define your investment goals (e.g. retirement, buying a home, education).
- Determine your time horizon for each goal.
- Consider seeking professional advice for personalized guidance.
-
- A financial advisor can help you with complex financial decisions and tailor your financial plan to your unique needs.
- Professional advice can give you a deeper understanding of how to balance risk tolerance and risk capacity.
- Prioritize ongoing monitoring and rebalancing.
-
- Conduct periodic reviews and make adjustments as needed based on changes in your personal circumstances or market conditions.
- Rebalancing your portfolio helps maintain your desired asset allocation and manage risk effectively.
Final Thoughts
Balancing risk tolerance and risk capacity is essential for an effective investment strategy. Risk tolerance reflects your comfort with market volatility, while risk capacity indicates your financial ability to absorb losses. Understanding both helps create a strategy that aligns with your emotional and financial needs.
Working with a dedicated financial planner to form a dynamic and comprehensive plan will prioritize achieving your specific goals with appropriate risk. Your planner will help identify your risk profile, set clear financial goals, and give you professional advice to help weather market volatility with confidence. They will regularly monitor and rebalance your portfolio to stay on track and adapt to your changing needs.
At SK Wealth, our committed financial planners specialize in guiding investors through strategic decisions on investment planning and implementation. Over the past 25 years, we’ve honed The Integrated Financial Advantage™, a distinctive financial planning process designed to offer clients personalized advice, empowering them to live with intention, both tomorrow and today..
