When building a portfolio, investors need to understand two types of risk: risk tolerance and risk capacity. Ignoring these factors can lead to negative consequences, according to Orlando-based certified financial planner Charlie Fitzgerald III.
Asset classes are categorized on a risk spectrum from conservative to aggressive. While safer assets like cash or money market funds offer stability, they typically deliver low returns. On the other hand, riskier assets such as stock funds can experience frequent and violent swings up and down but offer higher investment growth over the long term.
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Assessing risk capacity and risk tolerance helps individuals find the right balance. “They go together,” says Fitzgerald, a principal and founding member of Moisand Fitzgerald Tamayo. “It’s kind of like yin and yang.”
Risk tolerance refers to an investor’s comfort level with short-term market fluctuations. It is subjective and influenced by emotions. For example, someone may believe they have a high tolerance for risk, but panic and sell all their stocks after a market downturn, indicating a low risk tolerance.
Risk capacity, on the other hand, refers to an investor’s ability to take risks based on their financial situation and goals. It focuses on what level of risk is appropriate rather than personal preferences. John Hancock states, “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
Misjudging risk capacity and tolerance can lead to poor investment decisions. Here are a couple of examples shared by Christine Benz, director of personal finance at Morningstar.
In one scenario, a 23-year-old with a long time horizon invests all her money in a stable value fund because she dislikes market fluctuations. However, her high risk capacity suggests she can afford to take on more risk. Benz explains that her investments may experience ups and downs in the short term, but that won’t matter until she withdraws the money in 40 years. Her low risk tolerance is driving her decision-making process.
Conversely, a couple in their 30s who have a high risk tolerance invest their down payment savings in a global-stock fund. However, their low risk capacity makes this move overly risky. Benz warns that losses in the stock market leading up to a near-term home purchase could derail their plans.
In conclusion, risk capacity should take precedence over risk tolerance when constructing a portfolio that aligns with one’s time horizon. However, it’s important to note that emotions can still influence an investor’s decision-making process, so finding the right balance is crucial.
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