What’s the Difference Between Risk Capacity and Risk Tolerance?
By: Marla Mason
Ability to take on investment risk is a function of objective measures (the client’s financial profile) such as the investment goals, the time horizon for each goal, the need for liquidity, the client’s tax situation, and the unique circumstances facing the investor, such as a high ability to save, high salary, or low living expenses relative to income. Basically, the more a person can save, the longer the investor’s ability to take on risk. However, ability does not mean willingness, which is psychological in nature.
The term risk tolerance prevalent in the practitioner community—namely, an investor’s willingness to take perceived risk or the trade-off an investor is willing to make between the perceived risk and expected return of different investment choices. This definition derives from a psychological interpretation of the risk–return framework of classical portfolio theory. It treats risk tolerance as an attitude toward risk and decouples this pure attitudinal variable from the perceptions of risks and returns—psychological variables in their own right and distinct from the expected value and variance of the distribution of possible outcomes.