Before looking to invest, you must understand two critical pieces of information – Risk Tolerance and Risk Capacity. Understanding these concepts will help drive appropriate decision making around your investments and help mitigate undue stress or worry.
Key Takeaways:
- Risk tolerance refers to your ability to handle market swings and volatility of your investments
- Determining risk tolerance requires an understanding of your investment objectives, time horizon and how comfortable you are with a sudden loss.
- Risk capacity refers to how much risk you can bear given your financial situation and goals i.e. investing for a long time horizon such as retirement versus investing for a short or medium term horizon such as a house deposit.
How Risk Tolerance Works
Anyone can have a high risk tolerance in bull markets (i.e. when markets are rising). However, the best time to truly assess your risk tolerance is when the market is falling.
Think back to March 2020 during the initial onset of COVID-19. Global markets fell sharply in the face of a major global pandemic. Unemployment numbers soared, governments around the world initiated harsh lockdowns. The world confronted an unprecedented level of uncertainty, wondering whether COVID-19 would destroy the global economy.
What was or would have been your risk tolerance then? Did, or would you have hung on with your investments through those uncertain times? If you sold stocks in the midst of the panic, your risk tolerance was likely low.
Or, were you willing to invest more to take advantage of the market sell-off? If so, your risk tolerance was high, and it would have served you well as the stock market rebounded record-breaking numbers.
Investments with the potential for higher returns such as equities often come with a higher potential for sudden drawdowns.
If you don’t have the stomach for dealing with the risks of a sudden drawdown, even temporarily, you’ll have to settle for lower risk investments such as bonds and the lower returns that come with them.
Determining Risk Tolerance
Determining your risk tolerance depends on answering a few key questions:
- What are your investment objectives? Are you investing regularly and looking to grow the value of your nest egg? Or do you already have a decent nest egg and rather than grow it, are you looking to preserve it and live off of the income it generates?
- What is your time horizon – when do you need the money? Your time horizon is a crucial piece of the equation. The sooner you need the money, the lower your risk tolerance should be.
- How would you react if your portfolio lost 20 percent this year? Assessing your risk tolerance should involve thinking about hypothetical challenges, worst-case scenarios and your comfort with them.
Risk Capacity
Your risk capacity, or how much investment risk you are able to take on, is determined by your individual financial situation. Unlike risk tolerance, which might not change over the course of your life, risk capacity is more flexible and changes depending on your personal and financial goals—and your timeline for achieving them.
A young working professional just starting out in their career, saving for retirement has a long investment horizon. They can take on a significant amount of risk given time is on their side to weather any short term losses and bounce back.
But what if they’re saving to buy a house within the next year? In that case, their risk capacity will be low because they cannot afford to lose capital in the event of a sudden market drop.
Similarly if you are close to retirement, a sudden market drop could massively impact your quality of life in retirement if you hold the majority of your capital in risky assets.