Your risk tolerance is not your risk capacity. I’ve been having this conversation a lot with clients and thought it would make a good blog post. So, let’s get RISKYYYYYY.
We’re all here watching the stock market go up, down, and then up again. It can be a bit anxiety-producing if you haven’t taken the time to assess your goals, know what your money is supposed to be doing for you and made sure that each “bucket” of your money is invested appropriately (or not invested at all). However, if you’ve done that and are still concerned about the market, then it’s helpful to talk about risk tolerance, risk capacity and the difference between the two. Your thinking about both is also key to ensuring you’re not only achieving your financial goals but also living with less money anxiety.
Your risk tolerance is defined as the “ability to psychologically endure the potential of losing money on an investment.” Notice how it didn’t say, how much money you can afford to lose? In other words, it’s how much of the inevitable up and down swings in your portfolio that you can stand without feeling anxious, depressed or stressed. I would add that it should also include how much of the market volatility you can stand without making any potentially harmful and irreversible decisions.
It can be hard for individuals to assess exactly what their investment risk tolerance is, but one helpful exercise I find is asking
“How would you feel if you lost 15% of your portfolio within a month? How about 20%? 30%?” At what point would you begin to feel the urge to sell?
Doing that for your medium and long-term investments separately is really crucial as it allows you to understand your feelings around each. For example, you might feel sick if your kids’ 529 accounts lost 10% because you’ll need to enroll her in 6 years, but don’t blink at losing 20% in your retirement accounts because you still have 20 years until retirement. This website is a simple, straightforward way to compare your portfolio allocation to a model and see how much you could potentially lose in a given year.
Risk capacity is a more quantifiable idea, but one I don’t see many people discussing. It is basically how much risk can you afford to take from a dollars and cents standpoint. For example, if you have $100,000 saved in your daughter’s 529 accounts for college and you think it will only cost $80,000, you have the capacity to absorb a loss of 20%. How you feel about those potential losses is a different matter altogether, and would be your risk tolerance.
A few helpful questions to ask yourself regarding your risk capacity– When will I need this money? At what point would this actually affect my short-term financial situation? Have I over or under saved for this particular goal? Have I invested appropriately?
I’ve found that taking the time to think about and discuss these issues can be immensely helpful in reducing a lot of emotional stressors around money. Feel free to reach out if you want someone to help guide you through making the right decisions for YOUR financial situation.