The difference between risk tolerance & risk capacity
How emotional and financial factors shape how much risk you take on, and why they matter for your investing strategy.
By ATB Financial 12 January 2022 4 min read
Whenever there’s a possibility to gain in life, there’s risk involved. When it comes to investing, knowing how much risk you can handle is the foundation you need to help you reach your financial goals—and stay mentally healthy along the way.
When you start investing with ATB Prosper or decide to make a major change in your investment goal, you’ll be asked to create or update a comprehensive risk profile. Your risk profile protects you and helps to determine the investments that are right for you. It combines information about two distinct but related metrics: your risk tolerance and your risk capacity.
So, what are risk tolerance and risk capacity, and how are they different from each other?
Risk tolerance vs. risk capacity
Your risk tolerance is a measure of how much risk you’re willing to accept. Your risk capacity is how much risk you’re financially able to accept.
Risk tolerance is based on a gut check. It’s your best guess about how you’ll react emotionally when the value of your investment fluctuates. Many things can influence your risk tolerance: your age and stage of life, your temperament, your overall financial goals, the purpose of your investment and your previous investing experience.
As you see markets go up and down, you need to pay close attention to how you feel and react. This, combined with conversations with a financial advisor, can help you figure out how much risk you're comfortable with now and can help you adjust your risk tolerance over time.
Risk capacity, on the other hand, is based on a cold hard look at your total financial picture. It measures how a change in your investment value will impact you. What impacts risk tolerance also tends to influence risk capacity, with a few added factors:
- Your income
- Your net worth
- Liquidity: the percentage of the value of your assets that’s immediately available to you)
- The makeup of your portfolio: the different types of assets in your portfolio and their worth, volatility, and liquidity relative to each other)
- If you have financial dependents
- Debts and other financial liabilities
- Your investment timeline: when you’re able to cash out
Risk tolerance and risk capacity work together
Risk tolerance and risk capacity overlap and inform each other, but sometimes there can be a disconnect. It’s normal to feel like you can handle more risk than you can actually afford, especially if you’re new to investing.
Ideally, however, your comfort with risk is based on an objective picture of your finances. In this case, your gut check gets a reality check.
Here’s an example: you have an RRSP account with a long-term goal of saving for retirement, but you have a short term goal of using those funds within the next 2–3 years for a downpayment on a house. You may not have the risk capacity to purchase an investment (in this case, a short-goal of a downpayment) that might be negatively impacted by an investment that has higher fluctuations over the short term (the higher-risk, long-term goal of saving for retirement). When it’s time to withdraw your funds for your downpayment, you could find that the funds in your RRSP have fluctuated so dramatically that you have less money than you expected.
Using your financial goals to determine risk tolerance and capacity
The best way to figure out how to get somewhere is to have the destination in mind. The same goes for investing—your big picture financial goals can help you assess your risk tolerance and risk capacity.
Say you’re in your late thirties and investing with the goal of saving for retirement. That means you’re working with a long-term investment strategy and you won’t be trying to liquidate your assets any time soon. The slow, reliable growth of your investments is more important than a big spike in value.
It’s a different story if your goal is to get out of debt, save for a down payment or get enough capital for a business you plan on launching in the near future. Each of these goals will impact your timeline, investing strategy and liquidity needs differently—which means each goal will impact your risk capacity in different ways.
Other factors to help you determine your risk tolerance and capacity
Big picture goals shape your financial prospects and can help you set your priorities straight, but they aren’t the only things to consider when you’re trying to determine how much risk to take on. Make sure to factor in annual income, dependents, liabilities, short-term savings goals and the availability of an emergency fund.
Also, don’t forget to consider your mental health! This is where the gut check provides the reality check. Even if you have the financial capacity to deal with significant ups and downs in your investments, it’s still worth asking yourself if taking on that risk is going to cause you anxiety or have other negative effects on your mental health.
Want to take a closer look at how fluctuating investments might impact your finances, and your life?
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