Risk capacity and risk tolerance are two important concepts that investors should understand. Though they are related, they are not the same thing.
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.
Difference Between Risk Capacity & Risk Tolerance
Risk capacity is a measure of an investor’s ability to take on risk. It is determined by factors such as age, investment time horizon, and income.
Risk tolerance, on the other hand, is a measure of an investor’s willingness to take on risk. It is determined by factors such as an investor’s goals, risk aversion, and investment experience.
Investors with a high risk capacity but low risk tolerance may be more willing to invest in risky assets than their ability to handle losses would suggest. On the other hand, investors with a low risk capacity but high risk tolerance may be more conservative than their ability to handle losses would suggest.
The best way to find the right balance of risk and return for your portfolio is to work with a financial advisor who can help you understand your risk capacity and risk tolerance. With this information, they can develop an investment plan that is tailored to your individual needs and goals.
Do you know your risk capacity and risk tolerance? What asset classes are you comfortable investing in? – Read more about Investment advisory services by A&I
Written By: Marla Mason