Financial Fundamentals – Risk Tolerance vs. Risk Capacity
One of the reasons our clients hire us is to help make the complex world of investing easier to navigate. Sometimes it seems that those who work in financial services speak their own language. There tends to be a disconnect, or miscommunication, when we try and bring complex financial terms down to a more simple level. This is often the case with risk tolerance and risk capacity. While they sound similar, they hold very different meanings and can affect your financial plan in very different ways.
Consider the following example:
John has worked very hard to build up a nest egg. He has also done some research, and recognizes that historically the stock market has gone up more than it has gone down. John also understands that with more money in the stock market, there will be more volatility — the inherit rollercoaster ride. He is comfortable with having a large portion of his nest egg invested in the stock market — a decision that takes on more risk, but may receive a higher rate of return.
Through this example, we can assume that John has a high risk tolerance. Risk tolerance is the amount of risk you feel comfortable taking on. In the example, John is okay with the idea that the money he has invested could lose value, because he is confident that over the long-term, investing in stocks will provide better returns.
On the flipside, let’s examine John’s investments from a risk capacity angle:
John has worked very hard to build up a nest egg. While John was working, he saved for retirement and also received a pension. Now that John is retired, he is collecting Social Security income, along with his pension. Those income sources alone meet a majority of his needs, which means he is not reliant on withdrawals from his portfolio to maintain his lifestyle. In this example, John has the capacity to take on more risk, in other words have more money in the stock market, if he so desires.
From this example, we can see that while John might have a high risk tolerance, he also has a high risk capacity. Risk capacity is the amount of risk you can take on while still being able to reach your financial goals. Another way to think about it, is that risk tolerance is the amount of risk you can comfortably handle, while risk capacity is the amount of risk that is reasonable to bear, given your financial situation.
Risk tolerance and risk capacity interact in many ways to affect your investment portfolio. And, your risk tolerance and risk capacity levels often change as you move through different life stages. Ultimately, it comes down to your personal financial goals and it all starts with a conversation. Your Affiance Financial Advisor remains available to help determine your personal risk tolerance and capacity levels. Reach out to your Advisor to discuss your personal situation today.
Please remember there can be no assurance that the content made reference to directly or indirectly in this article will be profitable, or suitable for your individual situation, or prove successful. Moreover, you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized advice from Affiance Financial. Please remember to contact Affiance Financial, if there are any changes in your personal/financial situation or investment objectives.