Investment Risk Tolerance and Investment Risk Capacity: Understanding the Difference

Investment risk tolerance and investment risk capacity are two key concepts that play a crucial role in determining an individual’s approach to investing. While they both relate to the topic of risk, they represent different aspects and considerations. Let’s explore each of them in detail and understand their distinctions.

Investment Risk Tolerance:

Investment risk tolerance refers to an individual’s psychological and emotional ability to withstand the fluctuations and uncertainties associated with investing. It reflects a person’s comfort level with the potential ups and downs of the market and their willingness to accept the possibility of financial losses. Risk tolerance is subjective and varies from person to person, influenced by factors such as personality, investment experience, financial goals, time horizon, and overall financial situation.

Determining your risk tolerance involves assessing your willingness to take on risk and your capacity to handle potential losses without significant emotional distress. Some individuals may have a high risk tolerance, allowing them to comfortably invest in volatile assets with potential for higher returns, while others may have a low risk tolerance, preferring more conservative investments with lower potential returns but also lower volatility.

Investment Risk Capacity:

Investment risk capacity, on the other hand, is an objective measure of an individual’s financial ability to assume risk in their investment portfolio. It focuses on evaluating a person’s financial resources and constraints, such as income, expenses, savings, debt obligations, and overall wealth. Risk capacity helps determine how much financial risk an individual can afford to take without jeopardizing their financial well-being or ability to meet their financial goals.

Risk capacity takes into account factors such as income stability, diversification of assets, emergency funds, and other financial commitments. For example, someone with a stable job, ample savings, and minimal debt obligations may have a higher risk capacity and can afford to take on more investment risk. On the other hand, someone with a limited income, significant debt, or imminent financial obligations may have a lower risk capacity and should adopt a more conservative investment strategy to protect their financial stability.

Distinguishing Factors:

The main difference between investment risk tolerance and investment risk capacity lies in their respective focuses. Risk tolerance pertains to the individual’s psychological willingness to take on risk, while risk capacity relates to the individual’s financial ability to handle risk. Risk tolerance deals with the emotional aspect of investing, while risk capacity deals with the financial aspect.

Furthermore, risk tolerance is influenced by subjective factors and can change over time due to personal circumstances or market conditions. Risk capacity, however, is relatively stable in the short term and can be adjusted by improving one’s financial situation through income growth, debt reduction, or savings accumulation.

Understanding the distinction between risk tolerance and risk capacity is crucial in constructing an investment portfolio that aligns with an individual’s goals and circumstances. By considering both factors, investors can strike a balance between their emotional comfort and financial well-being, making informed decisions that support their long-term financial objectives while managing the inherent risks associated with investing.

 

In conclusion, while investment risk tolerance focuses on an individual’s psychological willingness to take on risk, investment risk capacity centers on their financial ability to handle risk. Both factors are essential considerations in building a suitable investment strategy that aligns with an individual’s goals, circumstances, and overall financial well-being.

 

Russ Lazaruk, RIAC, CIWM, CIM, FCSI

Managing Director & Portfolio Manager

NCP Capital Partners

250 999 3329