In many ways, financial planning is about reducing or mitigating risk. As you get older, some risks diminish while others increase. A good financial planner is skilled in helping you to reduce risk as much as possible, especially when it comes to funding your retirement.
But there are different kinds of risk and different ways of looking at it. Two perspectives on risk include risk capacity and risk tolerance. Even though both terms involve how you view risk, they’re very different, and each has unique impact on your financial strategy.
What Is Risk Tolerance?
Risk tolerance refers to the amount of risk an individual is comfortable with. This may be a relatively familiar term, especially because it can be applied to a variety of situations, including those outside the financial realm. However, when it comes to your financial plans, risk tolerance focuses on how much risk you can assume without it impacting your peace of mind.
Risk tolerance can also be likened to someone’s “appetite” for risk. Some people are “hungrier” for risk than others, while others have no taste for it.
For example, suppose you have $100,000 to invest. If you’re someone with a relatively low risk tolerance, you may choose to put the money in traditionally safe investments, such as:
- Certificates of deposit
- Government bonds
- High-yield savings bonds
- Treasury notes
For example, with a certificate of deposit, especially a relatively short-term one, there’s a very high chance of you getting your money back plus interest.
At the same time, risk also frequently mirrors reward. So even though a certificate of deposit provides you with a relatively secure investment, it may only pay out low-interest rates over one year.
On the other hand, if you have a higher risk tolerance, you may choose to invest some or all of your $100,000 in high-growth stocks. For instance, you could invest in an up-and-coming company or other tech stock, hoping to profit from a short burst of growth. Sometimes these stocks yield very high returns. At the same time, however, as mentioned, with high rewards come more risk. Due to unpredictable market factors, these companies’ stocks may also suffer significant drops in value, negatively impacting your investment portfolio.
What Is Risk Capacity?
Risk capacity refers to the amount of risk your finances can accept without endangering your desired lifestyle. In this way, risk capacity is somewhat less subjective than risk tolerance. While risk tolerance is based on emotion and feelings, risk capacity is based on hard numbers.
However, the process of deciding your risk capacity inevitably involves some emotion-based decisions. For example, before you can determine how much money you need to support your lifestyle and achieve your financial goals, you must establish a baseline, and for most people, this will involve contemplating:
- Where you’re willing to live, including the town, country, climate, and proximity to loved ones
- The kind of vehicle you drive, something which, for many, needs to be something they’re comfortable being seen in
- Your wardrobe, entertainment choices, and other auxiliary—yet important—lifestyle choices you need funds to support
- The assets you have and feel a need to hold on to, such as properties, stocks, vehicles, antiques, or anything else that could be used for collateral or impacted by a financial strategy
- Assets you’d like to leave to loved ones or others in your will
Despite the emotional pull of the above, your risk capacity will ultimately come down to some hard numbers. For example, when evaluating your risk capacity, you will most likely consider whether any of the following will be impacted by the fluctuating value of investments:
- The value of your stock portfolio
- Income from investments
- The effect changes in investment value may have on dependents
For example, to evaluate your risk capacity, you can ask a question like, “If this company I’ve invested in goes belly up, will I lose so much money that I won’t be able to support myself, leave a sufficient inheritance for my loved ones, or support my dependents?”
Balancing your risk tolerance and risk capacity can be complicated and confusing. For guidance, you can rely on the professionals at Williams Financial. With years of experience helping people navigate some of their most important investments and life decisions, Williams Financial is the kind of ally you need when making complex decisions. Discover more by connecting with us today.