While risk tolerance and risk capacity might sound like the same thing, they are actually two distinct concepts. Risk tolerance describes your comfort level with financial risk, while risk capacity defines your fiscal ability to take these risks. It is crucial that you define both of these factors for yourself before choosing how to divide your investment capital. Your income, age, investment goals, and current portfolio will all play key roles in determining your risk tolerance versus capacity — and how both may change over time.
What's the Difference Between Risk Tolerance and Risk Capacity?
While risk tolerance and risk capacity are related, one refers to the psychological side of trading, while the other refers to an investor’s practical ability. Your risk tolerance is your emotional and mental ability to endure market volatility, while your risk capacity refers to your actual financial ability to withstand losses.
Risk Tolerance
If you have a high risk tolerance, it means that you’re willing to make riskier investments with less guarantee of return. If you’re an investor with a lower risk tolerance, you’ll feel most comfortable investing in lower-risk assets — even if that means you might not see as high of returns.
While risk tolerance does not directly relate to the amount of money that you have available to invest, the two are usually closely associated. This is especially true if you’re investing for a major goal like retirement or buying your first home.
For example, if you’ve already maxed out your 401(k) for the year, you may have a higher risk tolerance with your remaining investment funds. You might want to invest in individual companies that you see potential in — if a stock you own goes to $0, you still have your retirement covered with your previous investments into stable funds. If you only have a small amount to invest, it’s usually a good idea to stick with lower-risk, tried-and-true investments like S&P 500 index funds and avoid individual stocks, which come with a greater risk of loss long-term.
Risk Capacity
Unlike risk tolerance, risk capacity is an objective measure based directly on available capital. If you cannot afford to purchase a share of stock from Company A, for example, it doesn’t matter how comfortable you are with the risk of dropping share prices — you cannot enter the position without sufficient risk capacity.
You can determine your risk capacity when investing by creating a budget that aligns with your household income. You may want to split your risk capacity between multiple sectors, limiting higher-risk investments to a smaller percentage of your total portfolio. A financial planner can be an invaluable tool in deciding what percentage of your income you should devote to each category of investment.
Importance of Aligning Risk Tolerance with Risk Capacity
It’s important that your risk tolerance and risk capacity align with your overall portfolio goals. This helps you maintain emotional stability during market fluctuations and avoid impulse buying and selling, which can disrupt long-term portfolio progress toward your goals.
Understanding your risk capacity keeps your investments in line with what you can afford to lose. This prevents financial strain and ensures that essential financial goals, like retirement or buying a home, are not jeopardized by excessive risk-taking. It also provides most investors with a defined reserve of funds they can specifically earmark for riskier investments like individual company stocks.
Balancing your risk capacity with your risk tolerance provides you with a realistic path toward achieving your long-term goals. Overinvestment in riskier assets may increase debt or force the liquidation of other assets to cover losses, undermining overall financial stability. However, avoiding risks altogether can lead to an opportunity cost, jeopardizing your goals.
Practical Ways to Assess and Align Risk Tolerance and Capacity
Aligning risk tolerance and capacity helps you create a sustainable investment strategy. There are many tools you can use to determine your individual risk capacity, as well as reassess whether your investments are still aligning with your goals or if you need to make changes.
Assessment Tools and Techniques
Financial planners and robo-advisors regularly ask new customers to take a risk questionnaire before recommending assets or sector investments. These targeted, simple question-and-answer tests are designed to gauge your emotional comfort with risk. Tools like Finametrica Risk Profiling assessment provide insights into your willingness to take on risk and recommend assets in-line with your goals and risk tolerance.
Software designed to manage household expenses can also be useful in determining your risk tolerance. For example, apps like You Need a Budget can help you identify areas in your current spending where you can afford to save. Because these funds were not originally accounted for when calculating monthly expenditures, you may be able to divert them to higher risk investments you may not normally have the tolerance or capacity to take on.
Regular Review and Adjustment
As your income, goals, and age change, your risk tolerance and capacity might change as well. For example, you could have a lower risk tolerance later in your career despite making more income than you did when you first started working because you’re getting closer to withdrawing those funds in retirement. This makes it especially important to remain dynamic in your asset allocation and regularly review and reassess risk tolerance.
At a minimum, you should conduct a comprehensive review of your financial situation and investment strategy once a year to confirm that volatility and returns are still at a tolerable level. You should also reassess and review your allocation at each major life event (like getting married or planning to start a family) and when your income changes. This helps you stay on track and avoid FOMO when making long-term investment choices.
Managing Risk While Investing
When determining your investment allocations, it's important that you have a solid understanding of your personal risk tolerance (your psychological ability to withstand volatile markets) and risk capacity (your ability to enter these positions financially). Aligning these two factors will help you determine and achieve your long-term financial goals with less stress.
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