There are two kinds of risk that investors should understand when building a portfolio: risk tolerance and risk capacity.
They describe different aspects of a person’s risk profile — and ignoring them can put investors “in a really bad situation,” said Charlie Fitzgerald III, a certified financial planner based in Orlando, Florida.
Asset classes sit on a risk spectrum from conservative to aggressive.
Safer assets, like cash or money market funds, are stable but have relatively low returns that may not deliver much if any growth after inflation. Riskier ones like stock funds are more volatile — meaning they can experience frequent and violent swings up and down — but deliver higher investment growth over the long term.
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Assessing risk capacity and risk tolerance helps individuals strike an optimal balance.
“They go together” said Fitzgerald, principal and founding member of Moisand Fitzgerald Tamayo. “It’s kind of like yin and yang.”
Risk tolerance is essentially an investor’s comfort level with short-term market gyrations. It’s a willingness to take risk and is personal, subjective and guided by emotion, experts said.
Someone may think they have a high tolerance for investment risk and steely resolve when faced with extreme volatility — but then freak out and dump all their stocks the second after a market selloff. Such a person would have a low risk tolerance.
By contrast, risk capacity describes an investor’s ability to take risk. Put differently: Can they afford to gamble?
“You may want to gamble on roulette, but your income and savings may tell you that you shouldn’t,” according to firm John Hancock. “Risk capacity ignores your wants — that’s your risk tolerance — and focuses on what level of risk is appropriate for you based on your situation and goals.”
Misjudging your investment risk can be costly
There are instances in which investors can misjudge their risk capacity and tolerance and make poor choices as a result.
Consider these examples from Christine Benz, director of personal finance at Morningstar.
In one case, a 23-year-old starts a new job and doesn’t like the idea of her savings losing value. She invests in her company 401(k) plan but allocates all her money to a stable value fund, the “safest” available option. But this worker has a long time horizon, and therefore a high risk capacity, Benz said.
“Her investments can go up, down and sideways in the months and years to come, but that won’t really matter until 40 years from now, when she’s ready to pull her money out,” Benz wrote. “But she’s letting her low risk tolerance … dictate her decision-making.”
In fact, financial advisors generally recommend young investors have a portfolio geared mostly if not entirely to stocks.
Now let’s take the opposite example. Here, a couple in their 30s are saving for a down payment on a house. They stayed invested in their company retirement plans through the 2008 financial crisis and feel comfortable about their ability to weather future downturns. They put their down-payment money in a global-stock fund.
The couple has a high risk tolerance — but a low risk capacity, Benz said. Subjecting a down payment to stock loss is overly risky: Investment losses leading up to a near-term home purchase could derail their plans.
Ultimately, risk tolerance, while important, is less so than assessing risk capacity and building a portfolio whose holdings “are a good fit for one’s time horizon,” she said. Of course, if an appropriately calibrated portfolio ultimately makes an investor anxious, there’s a chance the investor may be guided by their emotions to make a change at the wrong time, she added.
