Do you have a lead foot when you drive? Or are you a bit more cautious behind the wheel? Think of the sportiest cars you’ve seen on the road: The car is capable of comfortably reaching speeds exceeding 150 MPH, but as the driver, how comfortable would you be traveling beyond 150 MPH? In the world of finance, the difference between risk capacity and risk tolerance is summed up by what you can do versus what you want to do.
Aligning your investment choices with your capacity and tolerance for risk can help establish your financial philosophy as something representative of who you are and what your goals are. By understanding how these concepts complement each other, you can use them to help guide how you manage financial risk in your life. Let’s take a moment to address some of the ways risk tolerance and risk capacity can influence your finances.
The Role of Risk in Your Financial Decisions
Risk tolerance takes human nature into account and refers to your personal readiness to accept financial risk, while risk capacity is an objective measurement of your financial situation and its ability to manage potential volatility. To address risk capacity, you might ask, “How much can we afford to lose?” And for risk tolerance, you might think about, “How much volatility are we willing to endure?” The difference here is between your hard limits—based on tangible assets—and your soft limits that are based on your level of comfort.
You might be wondering whether risk capacity or risk tolerance is more important for making financial decisions. The truth is that your investment strategy should generally be considerate of both. While risk capacity is viewed objectively, and risk tolerance is subjective and psychological, your feelings matter and contribute to your overall financial security just as much as dollars do. But it’s also important to remember that risk tolerance and risk capacity aren’t inherently good or bad; no matter where you are on the risk spectrum, positive and negative outcomes are all possible.
So, how do we measure them?
Risk capacity is determined by your financial situation (e.g., your debt, income, goals, liquidity needs, and expenses) and your timeline. If you’re 25, you may have high risk capacity because you would theoretically have more time to recover from market volatility. For example, if you’re 64 and retiring next year, considering other factors, your risk capacity may be low because your potential for future earnings to help you recoup an investment loss is also low. But age isn’t the only factor—if you have a sizable emergency fund, your capacity to withstand risk might be higher. Or consider this: maybe you’re a high earner but also have high expenses. Here, your risk capacity could potentially be on the lower side because you may not have much flexibility to lose money without significant changes to your lifestyle.
As for risk tolerance, it is your emotional willingness to handle the volatility and uncertainty that comes with risk-taking activities. Risk tolerance is subjective and can change based on personality, past experiences, and emotions at any given time; that’s why it’s critical to be honest with yourself about your financial situation and your long-term goals. Some people are naturally risk-averse, while others are more adventurous, and some assess risk differently depending on what’s at stake.
So, what can happen if your risk capacity and risk tolerance are out of alignment?
When you have high risk capacity but low risk tolerance, you have the time and money to invest aggressively, but you’re apprehensive about market dips and other threats to your principal. Choosing safer investments can help shield your principal investment from losing value, but that also means you might miss out on growth or fall short in overcoming inflation. When you have low risk capacity but high risk tolerance, you might find yourself chasing big returns without the resources to back up any potential losses. For example, if the market and your portfolio dip together, but you’re relying on your portfolio to cover costs, you could be forced to sell at a loss, shortening your financial longevity.
Your finances are about more than cold, hard cash. The human element of decision-making can’t be ignored, and it can influence your retirement just as much as your account balance. That’s why it could be important to have a financial strategy that helps instill confidence, no matter what the situation is. For example, you might reevaluate your risk capacity when your salary changes, or you might find your risk tolerance being tested when the market slips. At the end of the day, you should remember that both of these concepts are flexible, and it’s possible that your current capacity or tolerance for risk could be misaligned with your long-term financial goals.
But that’s what we’re here for. We can help you recognize and calibrate the risks that influence your financial outlook, so call us today to get started.
