Determining the right investment strategy is crucial for achieving long-term financial goals. Two key factors that play a pivotal role in shaping an individual's investment approach are risk tolerance and risk capacity. While these terms are often used interchangeably, they carry distinct meanings, each influencing how investors should approach investment selection.

Defining Risk Tolerance

Risk tolerance is a subjective measure of how comfortable an investor is with the potential for loss in their investment portfolio. It's influenced by factors such as financial goals, time horizons, and personal temperament. Essentially, risk tolerance reflects the investor's emotional and psychological ability to withstand the ups and downs of the market without making hasty decisions.

Understanding your risk tolerance involves introspection. Are you willing to endure short-term losses for the possibility of long-term gains? Or does the idea of even a small loss keep you up at night? Investors with a higher risk tolerance are generally more resilient during market downturns, while those with a lower risk tolerance may opt for more conservative, stable investments to mitigate potential losses.

Evaluating Risk Capacity

On the other hand, risk capacity is an objective measure of an investor's financial ability to absorb losses without jeopardizing their overall financial well-being. It takes into account factors such as income, assets, liabilities, and other financial obligations. Unlike risk tolerance, which is more about feelings and attitudes, risk capacity is rooted in the cold, hard numbers of an investor's financial situation.

Determining risk capacity involves assessing one's ability to meet financial goals despite market fluctuations. For instance, an investor close to retirement may have a lower risk capacity due to a shorter time horizon for recovering potential losses. Conversely, a young investor with a stable income and minimal financial obligations may have a higher risk capacity.

The Crucial Interplay

While risk tolerance and risk capacity are distinct concepts, they are interrelated and should be considered together when crafting an investment strategy. Striking a balance between an investor's emotional and financial resiliency is key to creating a portfolio that aligns with their overall goals.

For example, an investor may have a high risk tolerance, indicating a willingness to embrace market volatility. However, if their risk capacity is limited due to financial constraints, it may be imprudent to allocate a significant portion of their portfolio to high-risk assets. Conversely, an investor with a low risk tolerance may opt for conservative investments, but if their risk capacity allows for a more aggressive approach, they might miss out on potential returns needed to meet their financial goals.

A cautionary word about risk questionnaires

By definition, risk tolerance is subjective, and therefore it’s not easy to quantify. Many advisors use a “risk tolerance questionnaire” as a shortcut to plugging investors into certain portfolios rather than doing the hard work of understanding their individual goals, their financial situation, and their lived experiences with risk.

Another problem with these tools is that our attitudes toward risk vary situationally and over time. When markets are soaring you’re likely to score higher (bring on the risk!), and when markets are falling you’re likely to be more risk-averse (yikes! sell everything!). Long-term investing success requires the exact opposite of these normal behavioral biases. As Warren Buffet said, “Be fearful when others are greedy and greedy when others are fearful,” or if you prefer, “buy low, sell high”.

This is not to say risk tolerance questionnaires are of no value, rather their real purpose is to start a conversation. Feel free to take the questionnaire yourself and see what kind of portfolio matches your risk tolerance score: OWS Risk Tolerance Questionnaire. But, remember, this is only a conversation starter. Creating a portfolio that is most likely to align your attitudes toward risk with your financial situation and your goals requires a much deeper dive.

What’s your Risk Tolerance?*

Click here to take our 3-minute quiz and start the conversation.

*Knowing your risk tolerance is critical to achieving long-term investing success, but you should not base your investment decisions on the results of a quiz! This is just a tool to start a deeper conversation.