Your risk profile is your guide when choosing an investment that matches your needs. It takes 2 things into account: your risk tolerance and risk capacity.
Though often used interchangeably, these are not the same thing. Learn the difference so you can gain a better understanding of how to manage risks as an investor.
What’s the difference between risk tolerance and risk capacity?
Put simply, risk tolerance is how much risk you can handle emotionally while risk capacity is the amount of risk you can take given your financial health and ability.
Risk tolerance is mostly psychological. It tends to be influenced by your personality and biases, attitude towards money, and financial situation. Major life events may also shape your comfort level with risk.
A quick way to know your risk tolerance is to ask yourself: “How would I feel about and react to an investing loss?”
Meanwhile, risk capacity is impacted by largely material factors such as your income, obligations, and time horizon (or when you’ll need to take money out of your investments).
To gauge your risk capacity, you can ask: “How much risk can I take while staying financially healthy even if I lost money?”
Why are they important to know?
Your risk tolerance and capacity can influence each other, but they may sometimes be at odds. For example, if you’re earning just enough to cover daily needs (financial ability), you may be unwilling to expose your money to any risk (comfort level).
On the other hand, if you’re young and still starting out in your career, you might feel like it’s OK to be an aggressive risk-taker. Being young means you have time to make changes in case of poor decisions or wait out bad market conditions.
However, if you don’t have emergency savings or instead have a lot of debt, this might mean you can’t actually afford to take such risks.
It’s important to understand and consider both when making investing decisions so you won’t get exposed to too much risk.
Aligning your risk tolerance with your risk capacity will also help you stay on track with your money goals. When you keep your emotions in check, you’ll avoid acting on impulse and making ill-informed moves.
You’ll also steer clear of financial troubles when you risk only the money you can afford to lose. By striking a balance, you’re less likely to disrupt or slow your progress toward goals.
Remember that these 2 things – along with your risk profile – can change over time.
Your emotional acceptance of risk may evolve as you go through life events and learn more about money management.
Your risk capacity may also improve as your financial standing gets better. That’s why it’s ideal to take a risk assessment periodically to know if your situation has changed.
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