ady to jump into the world of investing? Or perhaps you’re an existing investor looking to conduct a little sense check.
When it comes to investing your hard earned money, risk is an inevitable factor and a part of the process. But not all investors have the same relationship with risk, and none have the same personal or financial circumstances.
Therefore, before you start, it’s crucial to understand your relationship with risk and the difference between two key concepts – Risk Tolerance and Risk Capacity.
These two concepts are often misunderstood or used interchangeably, but in reality they are very different.
As part of a formal Financial Plan, investing is a great way – if not the only way – to grow your wealth and achieve your long-term financial goals.
And understanding the difference between your Risk Tolerance and Risk Capacity will help you to make more informed investment decisions and create a portfolio that aligns with your Financial Plan and long-term goals (to ensure you reach them!).
Risk Tolerance:
Risk Tolerance is the degree of risk an investor is willing to take on in pursuit of investment returns.
It is an emotional or psychological measure, as it reflects an investor’s willingness to accept the possibility of losing money in exchange for the potential for higher returns.
Think of it this way: Risk Tolerance is like your emotional “gut feeling” when it comes to taking on risk.
Do you feel like a high-stakes gambler? Do you like the highest, wildest slide at the waterpark?
Or are you more of a cautious investor? Do you prefer the lazy river at the waterpark?
Investors with a high Risk Tolerance are comfortable taking on more levels of risk and are comfortable seeing the value of their portfolios fluctuate around in the short term (day to day and month to month) if it means higher potential returns, while those with a lower Risk Tolerance prefer investments that are less volatile and provide a smoother experience at the cost of lower potential returns.
Your Risk Tolerance can be influenced by a variety of factors, such as your age, personal or financial circumstances, goals, and individual personality. For example, younger investors with a longer time horizon may be more willing to take on risk in exchange for the potential for higher returns, while retirees may prioritize capital preservation over growth. Similarly, “thrill seekers” who enjoy taking risk in general throughout their lives, tend to be more comfortable with more risky investments than the average personality type – for example a sky diving instructor versus a teacher.
Risk Capacity:
Risk capacity, on the other hand, is the amount of risk an investor can afford to take based on their financial situation and investment goals.
Unlike your tolerance for risk, your capacity to take on risk is not subjective – it is an objective measure determined by your financial situation and future goals.
Risk Capacity reflects an investor’s ability to withstand or absorb falls in the value of their portfolio without compromising their financial well-being – according to the FCA in the UK, ”if any loss of capital would have a detrimental effect on their standard of living, this should be taken into account when assessing the risk the client is able to take”.
Think of it this way: Risk Capacity ignores your emotional “gut feeling” when it comes to taking on risk, and instead focuses on your actual ability to take on risk.
To use the same examples:
Perhaps you like the highest, wildest slide at the waterpark – but you can’t go on it because you are a professional athlete, and your employment is contingent on you avoiding such risks in your personal time and remaining injury free.
In contrast, perhaps you like the lazy river – but you’re young, fit, and healthy, so you could easily ride the highest, wildest slide in the waterpark if you wanted to.
Investors with a high Risk Capacity have the financial resources to absorb falls in value, while those with a low risk capacity may not be able to afford to take on as much risk.
Your capacity for risk will be influenced by factors like your income, job security, assets, liabilities, and other financial obligations.
For example, consider two investors: Jane and David:
|
Jane |
David |
|
High Net Worth |
Lower Net Worth |
|
6 months’ worth of expenses tucked away in an instantly accessible emergency fund |
Less than 1 months’ worth of expenses saved and generally lives pay cheque to pay cheque |
|
Secure job and multiple sources of income |
Slightly concerned over job security, which provides his sole income |
|
No Debt |
Has both a mortgage and a car loan |
|
Has a clear Financial Plan in place as a roadmap for the future |
No formal Financial Plan in place and has not really planned for the future |
Jane is far more likely to be able to absorb short-term falls in the value of her investment portfolio without any impact on her day-to-day life, while David is far more likely to have to dip into his investment portfolio to meet his financial obligations on short notice. He will have no control or choice if this coincides with short-term falls in the portfolio’s value, forcing him to realise losses.
Thus, Jane has a far higher capacity for risk (or “Risk Capacity”) than David.
The Difference:
The main difference between Risk Tolerance and Risk Capacity is that Risk Tolerance is subjective and reflects your emotional willingness to take on risk, while Risk Capacity is an objective measure of your financial ability to take on risk.
While they are related concepts, a high Risk Tolerance doesn’t mean you have a high Risk Capacity, and vice versa.
For example, we often meet people with a high Risk Tolerance but a low Risk Capacity – they might be comfortable taking on risk to achieve the highest possible returns, but they do not have the financial ability to absorb the potential falls.
Similarly, we regularly meet the opposite type of people too: a low Risk Tolerance but a high Risk Capacity – usually people who are slightly nervous about investing, are unsure as to what “risk” actually means, and so are hesitant to take on risk and thus initially have a very low Risk Tolerance. But after getting to know them, they actually have a high Risk Capacity and could potentially take on more risk than they initially thought.
Both factors should be considered separately and dovetail to create the perfect personal investment strategy for you.
Conclusion:
Once you have determined your Risk Tolerance and Risk Capacity (and have a Financial Plan in place), you can get started on creating an investment portfolio that aligns perfectly with your Financial Plan and long-term goals, but crucially allows you to sleep at night in the meantime.
Your portfolio should strike the perfect balance between risk and reward, taking into consideration your personal preferences and financial circumstances.
It’s also important to remember that both your tolerance and capacity for risk can – and probably will – change over time. As you get older and your financial life evolves, your willingness and ability to take on risk will likely change as well. It’s a good idea to reassess your Risk Tolerance and Risk Capacity periodically to ensure that your investment portfolio remains aligned with your Financial Plan.
So, take the time to assess your Risk Tolerance and Risk Capacity, and to make sure you’re invested properly today. That way, tomorrow should be just as you planned it.
And if you’re an expat looking for help in understanding your Risk Tolerance, Risk Capacity, and setting up an appropriate investment portfolio for you, please do get in touch – our team of highly qualified Financial Planners would be delighted to help.
By Adam Dalby – Chartered Financial Planner