Understanding your risk tolerance vs risk capacity
A common, but incorrect, myth is that investing is too risky. It’s understandable how someone could feel that way, given the fact that investment returns are in no way guaranteed. But the good news is that investing allows you to choose the right level of risk for you so that you can achieve your financial goals in the long term, even if you experience some losses along the way.
In the context of investing, risk is the likelihood of potential losses. To determine the right level of risk for you, you must consider two essential concepts: your risk capacity and risk tolerance, and the relationship between them.
What is risk capacity?
Risk capacity is a quantitative measure that takes into account your entire financial situation to help you determine how much risk you can take, and consequently, the dollar value you can afford to invest.
Determining your risk capacity
Your risk capacity is determined by evaluating factors such as your age, income, expenses, assets, liabilities and goals. As you go through this process, ask yourself questions such as:
1) How would potential losses affect you?
2) Do you have enough savings to sustain such losses?
3) How would such losses impact your ability to achieve your goals?
This evaluation process will help you determine the amount you can invest – i.e., your risk capacity. For example, all other things being equal, someone who is planning to buy a house in 2 years will have a lower risk capacity than someone wanting to buy a house in 20 years since they will need access to their funds much sooner.
It’s important to remember as your personal circumstances change, your risk capacity will also change. For example, if you receive a promotion and your salary increases, all other things remaining constant, your risk capacity will likely increase. It is best practice to reevaluate your risk capacity at least once a year.
What is risk tolerance?
Where risk capacity is a quantitative measure, risk tolerance is a qualitative measure that takes into account your personal feelings and preferences to help determine how much risk you want to take.
Risk evokes different emotions in different people. For some, it may mean something exciting and rewarding; for others, it may mean something scary and taxing. Where you fit on this spectrum will impact your investment strategy.
Determining your risk tolerance
In order to understand your risk tolerance, ask yourself how much you are willing to lose for the level of potential gains. If you would rather “not lose $100 vs. gain $100”, your risk tolerance would be lower than someone who would rather “gain $100 vs, not lose $100”.
It’s human nature to avoid losses rather than achieving equivalent gains, so never feel pressured to take on more risk than you’re comfortable with. Remember, the great thing about investing is you can choose the right level of risk for you!
How this translates to investing
Before you start investing, it is important to dedicate time to understanding your personal risk situation. As you undertake this process, be mindful that your risk tolerance and risk capacity may not always be in sync. If your risk capacity exceeds your risk tolerance, your portfolio may not be optimized for your circumstances. On the other hand, if your risk tolerance is higher than your risk capacity, you may be subjecting yourself to unnecessary risk.
Determining the right level of risk for you isn’t always easy. At Finch, we help you through this process. Our brief onboarding questionnaire is designed to help us understand your risk capacity and risk tolerance. From there, we recommend a personalized investment portfolio to match your unique risk profile.
It is important to review your investments at least once a year. Depending on the circumstances, your risk capacity and risk tolerance may change, and you will need to adapt your portfolio accordingly. Finch helps ensure your investments are aligned with your risk profile at all times.
With Finch, you can take on the right level of risk for you!