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Just because you have a high level of tolerance for risk does not mean that you have the same level of capacity for risk. These are quite different concepts and I am suggesting that as investors we should understand the difference. In this post I will explain my interpretation of the two types of risk.
Risk Tolerance
Risk tolerance is the what most investors are used to thinking and reading about. It is that “can I sleep at night” principle that we often read about. If you buy a particular asset, say Citigroup, are you comfortable holding that stock for the long term or will it cause you enough stress that you will not be able to relax and get a good nights rest? In other words, how much risk do you WANT to take.
Risk tolerance is crucial because it can greatly influence your emotional reaction to your portfolio. Invest too far out of your comfort zone (your appropriate risk tolerance) and you risk buying or selling for the wrong reasons. You will react improperly to wild swings in the markets and you hurt your portfolio.
Risk tolerance is typically divided into classifications such as conservative, balanced, or aggressive. Each level helps to determine what percentage of equities to hold and essentially helps to balance out the risk.
Risk Capacity
Risk capacity on the other hand is the amount of risk you NEED to take to reach your financial objectives. This is very different from risk tolerance in that it is a focus on need versus want. What do you need from your portfolio to meet your goals? Let’s say you need $2 million of portfolio assets to meet your retirement income goals of $80,000 per year. Based on your current savings of $100,000 and monthly additions of $750 dollars this means you will need to achieve a portfolio return of 10% per year (totally hypothetical numbers). To achieve this, an investor will need to take on a certain level of risk. This is your risk capacity.
The trouble for investors comes when the risk tolerance and the risk capacity are not aligned. More often than not investors have a risk tolerance that is too low for their required risk capacity. I am not suggesting that investors take on too much risk. I am suggesting that proper risks should be made based on the needs of the investor and their portfolio requirements. There must be alignment.
If you want to understand what your risk tolerance and your risk capacity is, then check out the online tool at MSN. It will provide you with some insight into your own alignment and what you need to do to
I think a more dangerous situation is when your risk tolerance is greater than your risk capacity. I’m sure more than a few fortunes have been lost because their former owners took more risks than necessary to reach their goals.