Risk can be defined differently depending on the investor and what is most important to them. For some investors, the potential loss does not outweigh the possibility of gain by not investing. If the risk of loss is high for other investors, the possible gains will not entice them to invest in a high-risk venture. An investor must use risk tolerance and risk capacity to determine where they fall.
Risk tolerance and risk capacity are two concepts that sound the same but are not. These concepts need to be understood before making investments. Used together, risk tolerance and risk capacity can help an investor determine the amount of risk that can be taken in their investments. Once the risk is identified and the investor sets a target of how much money they want the investment to earn, an investment plan can be constructed. Here are the differences between risk tolerance and risk capacity and their importance for an investor.
Risk Tolerance
Risk tolerance is the amount of risk that an investor is comfortable taking. It is also the degree of uncertainty that an investor can tolerate (thus the name.) Risk tolerance varies depending on many factors, such as age, income, and the financial goals of the business owner. Risk tolerance should be taken seriously when making financial investment decisions. If you don’t have millions to spare, your tolerance may be lower than someone who won’t feel the loss. Many methods can be used to determine an investor’s risk tolerance that will help them make riskier investments with the lowest amount of stress possible. Here are some of those methods.
- Self-administered risk tolerance questionnaire
- An online risk tolerance calculator
- Hiring a professional financial advisor
- Videos and other learning tools
Risk Capacity
In contrast to risk tolerance, risk capacity is the amount of risk that the investor needs to take to reach their financial goals. Examining goal time frames and the income required to achieve the financial goals is necessary to determine return estimates. Then, the rate of return estimate is used to help the investor decide the investments in which to invest and the level of risk they will hold. The primary key to determining risk capacity is the income goal.
Balancing the Two
Risk tolerance and risk capacity work together to determine the amount of risk and what type of investments to make. Risk tolerance depends on the investor’s financial plans, job, income, and age. In comparison, risk capacity has more to do with income and financial resources.
The two concepts have to be balanced for the investor to benefit financially from the level of investment they choose. If the amount of income necessary to reach the goals exceeds the investor’s risk tolerance, there will be a shortfall in achieving financial goals. Those with a higher risk tolerance are generally investors who aren’t concerned with losses. Conservative investors have a lower tolerance. Though they are low risk, low reward, they do fairly well with steady returns. Patience is the key for these investments.
Conclusion
Risk is a part of life in many aspects. When it comes to investing, risks range from imperceptible to losing it all. Using risk tolerance and risk capacity will help investors use their income and tolerance to reach their financial goals while managing the risks (and stress) that investing holds. To get the best assessment of both risk tolerance and risk capacity, do your research but also hire a professional financial advisor to assist in your investment decisions. A professional financial advisor will be able to better inform you of your best investment options.
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