Risk Tolerance vs. Risk Capacity

Written by Nickel - 5 Comments

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When determining your ideal asset allocation, it’s important to balance your risk tolerance with your risk capacity. As similar as these terms sound, they’re actually quite different.

What is risk?

For starters, the term ‘risk’ refers to the probability that an action or event will negatively or positively impact your ability to achieve your objectives. Most commonly, people use this term in the context of negative impacts, but remember the old mantra: with risk comes reward. In mathematical terms, risk is defined as the probability of an event occurring x the impact of that event occurring.

What is risk tolerance?

As an investor, you’re probably quite familiar with the concept of risk tolerance. Simply stated, risk tolerance reflects your attitude toward risk. Are you comfortable with investments that might produce dramatic swings in your portfolio value over time? If so, then you’re relatively risk tolerant. On the other hand, if these sorts of things would keep you up at night, then you’re relatively risk averse.

What is risk capacity?

Unlike risk tolerance, which essentially reflects the amount of risk that you want to take, risk capacity reflects the amount of risk that you need to take in order to reach your goals. Thus, rather than being an emotional construct, risk capacity is grounded in the reality of your situation. In other words, how much investment risk do you need to take on in order to <fill in the blank> in x years? Conversely, how much of a loss could you withstand and still meet thse goals given your time horizon?

Why does this matter?

The reason that I bring this up is because there’s often a disconnect between an investor’s risk tolerance and their risk capacity. Even if you’re a “nervous nelly”, you still need for your assets to perform as well as the next guy’s if you have similar goals and a similar timeframe. On the flip side, even if you have nerves of steel, that doesn’t necessarily mean an uber-aggressive portfolio is right for you. It depends on your circumstances.

If you’re curious how your risk tolerance and risk capacity compare, I encourage you to check out this quick little twenty question quiz. This should give you at least a rough idea for how your risk tolerance and risk capacity compare.

In case you’re wondering, my tolerance and capacity are pretty well aligned, as I scored 34 and 35, respectively.

Published on May 6th, 2009 - 5 Comments
Filed under: Saving & Investing
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About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

Comments (scroll down to add your own):

This is a message that we all need to be reminded of constantly. My experience tells me that we are fine with risk……as long as the market is going up. When we hit the rough patch….it’s another story.

Thanks for the important reminder.
Comment by Neal Frankle — May 6th 2009 @ 9:44 am
The idea that “with risk comes reward” is certainly the conventional investing wisdom. I don’t think this idea stands up to scrutiny.

Stocks are clearly a riskier asset class than money market accounts. So, according to the conventional wisdom, stocks should always offer a better long-term return. But, if you perform a regression analysis on the historical stock-return data to determine the likely long-term return for stocks at the top of the recent price bubble, the number you get is a negative number. Money market accounts beat that.

I believe that we need to be rethinking the conventional advice about stock investing in general and about risk in particular. I believe that what investors are really compensated for is for taking on PERCEIVED risk. The real risk of stocks was sky high at the top of the bubble. But stocks were so popular that the perceived risk was just about zero. That’s why stocks were paying a lower long-term return than money markets at the time.

Rob
Comment by Rob Bennett — May 6th 2009 @ 10:51 am
Rob makes a valuable point — I don’t think it contradicts the original blog’s point, but it adds a dimension to the discussion of risk.

Traditional measures of risk are kind of two-dimentional — they tend to be based on the frequency and magnitude of fluctuations. A better model would be three-dimentional, where the extra dimension is price. The higher prices go, the higher the risk.

I used to explain this to clients as being like the risk of falling off a ladder. It’s useful for me to know that there is a 10% risk of me falling off the ladder, but I process that information differently if I am on the first rung or if I am 30 ft. up.
Comment by Richard Barrington — May 6th 2009 @ 3:40 pm
Good post and great comments. While the survey is a pop-quiz, and too much should not be read into it, some questions defy easy answers – for example:
If you lost 20% of your investment in one day would you:
1) pull your remaining money
2) do nothing
3) invest more

It depends on why an investment lost 20%. One of the primary reasons why people got badly burnt in the last year or so is because they did not strategize on how to protect themselves on the downside. There are times when one must bite the bullet and get their money out to prevent losses. When to do so is perhaps one of the toughest decisions in investing.
Comment by GM — May 6th 2009 @ 4:58 pm
The best way to sum up the risk discussion is this: risk is the price you never thought you’d have to pay.

As for the discussion about throwing out the old advice, etc. Only time will tell, but it is normal for markets to go through 15 or even 25 year stagnant periods. Going back to the 19th century, you see similar patterns emerge. We peaked in 1999/2000 and prices have been stagnant since. If we go until 2015 or 2025, it’s problematic for investors, but what better alternative is there to asset allocation? I have yet to see one.

In the area of stock investing, Smart Money had a great article with a bunch of old line investment managers that were around for the crash in 1929. They were Ben Graham disciples and their investment discipline has held up over the years. I don’t see a broken system, just a lot of broken portfolios. It’s fairly obvious from the data produced by the 401k industry that most were overpositioned towards equities relative to age.

In working with clients, I would always show a Morningstar report comparing two portfolios. One with more equities exposure and more risk and the other with a little less equities and a lot less risk. The returns were typically within a percent of one another while the risk was usually reduced by one-third. I had not one client pick the riskier portfolio. Often it’s about making educated decisions–something in short supply when times are good. Now that things are in the toilet, I’m hoping more people will get involved with their finances, read blogs, research their investments, and turn off CNBC:)

Great topic
Comment by Michael Harr @ Wealth...Uncomplicated — May 8th 2009 @ 11:31 pm

Type of rates
- CD rates
- Money Market rates
- Savings rates
- Mortgage rates
Money to invest
< $10,000
Term
Up to 1 year
Money to invest
< $10,000
Desired Loan Amount
Loan Type
Refinance Purchase
State

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