What is your risk tolerance? Recently I met with a couple who had a very low risk tolerance and a very high risk capacity. So what is the difference? One of the ways you might define it is that people with a high risk tolerance view market downturns as temporary. They are able to stay invested during the ups and downs of the market. Someone with a low risk tolerance perceives market downturns as permanent, without the ability to recover in their lifetime. They fear losing money and are risk averse.
Risk tolerance has more to do with a person’s emotions and their reaction to risk, instead of their actual circumstances.
Risk capacity is the ability of a person to withstand market risk. Someone who has a high risk capacity is someone who might have high fixed income streams, has other sources of income (such as rental properties), income from a business partnership, or current wages. It could also be someone who only spends 1–2% of their portfolio or doesn’t plan on spending any money from their portfolio now or in the next 10 years. This person could be 10 years old or 90 years old. It depends on their situation.
A person with a low risk capacity might be spending anywhere from 4–10% of their portfolio and have no other fixed income streams other than Social Security or unstable wages. They could be just starting a career in their 20’s or close to retirement. In either case, they may not have the ability to take on much risk without eroding the capital in their portfolio and derailing their financial goals.
We believe that in order to be a successful investor, it is important to understand these concepts. If risk tolerance and risk capacity don’t match, it is important to make sure your financial plan is intact and that adjustments do not need to be made.