Risk Tolerance Vs Risk Capacity: Knowing The Difference
July 10, 2020
The economy that we all wake up in each day under COVID-19 looks a lot different from the one that existed before the virus took hold in the United States and around the world. It has been a major point of reflection for people all around the world. Many are reviewing how they have ran their personal financial life up to this point and reconsidering some of the steps that they have taken. As such, one of the items that some have looked at is their risk tolerance versus their risk capacity. The two are different, and we want to explore why that is.
The amount of risk that a trader is comfortable with taking on is a personal choice and something that each person has to decide on their own. People have different risk tolerance levels often based on factors such as their age, income, and goals. All of these factors can determine how much they want to put on the table because they are constantly doing mental calculations about how much they need that money and how much they seek to earn.
Getting the right risk tolerance level for an individual can help that person avoid some sleepless nights as they don’t have to stress staying up day and night worrying about their portfolio.
This is a bit different from risk tolerance in that it is the number that an investor has to put at stake in order to reach their financial goals. This number can certainly different from risk tolerance in a lot of ways. After all, one may not feel completely comfortable with how much money they have to put at risk in order to get to their goals, but that does not mean that the number is inaccurate.
The risk capacity number is determined by a time frame that someone has to actually reach their goals as well as what the exact number of dollars that someone needs to reach the goals that they do have. Knowing this number is important because an investor can take their risk capacity number and try to use it to make themselves feel more comfortable with their risk tolerance number. It is a psychological game that we all have to play with ourselves, but just knowing this number alone can be extremely helpful.
Getting The Balance Right
People fall either on the too conservative or too aggressive side of their risk tolerance. They can review those numbers and see which side of the ledger they happen to fall on. A lot of people need to tone down how much risk they are taking on and realize that they do not have to earn their entire retirement all at once. However, there are also some individuals who need to be told to pick it up a little.
Everyone has different goals and a different length of time to reach them. COVID-19 has put a lot of fear into the market, and many investors are getting too conservative in their approach at this time. This is the wrong move to make. The pandemic does not know when you are set to retire, and it does not know what your objectives are. You have to review all of that information for yourself and make the wisest choices based on your current state in life and what your plans are going forward. Consider the way that the world has changed, but understand that you should not be overly fearful because of the situation that exists today.