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 these goals given your time horizon?
Does it matter how much money I have to invest?
The amount of money you have available to invest might play a significant role in determining your risk tolerance. If all you have is $1,000 and you’re relying heavily on that money, you might want to take a more conservative approach. If you have $1 million on the other hand, you might feel more free to take risks.
The alternative might be true as well though. If you’re just starting out in the investing world and all you have is $5, you might be more than happy taking risks. If you lose it all, it’s just a fiver. In any case, the amount of money you have will play a significant role in your risk tolerance and risk capacity.
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.