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Risk Tolerance vs Risk Capacity

As the warning signs of a recession become graver and inflation shows no signs of abating, many Americans are reevaluating their attitudes towards risk – both in how they perceive and manage it. This isn’t a bad thing – it’s extremely important for us to understand our risk tolerance and to rethink things from time to time; it’s actually one of the most important aspects of investing and one that a quality financial advisor will take great care to glean out of you. So, how can you determine your risk tolerance? First, we should clear up some terms.

Risk Capacity

Most people see risk tolerance through the lens of possible profit and loss. Basically, the more you risk, the greater potential gains and losses, and if you’re able to sustain a great loss without compromising your goals, one would say that you are very risk tolerant. Perhaps a better term for this is risk capacity. But Risk capacity says nothing about your personal preferences. Rather it only shows how much risk you are capable of taking on without breaking your budget.

Risk Tolerance

Risk tolerance, on the other hand, may depend on many factors and is more flexible over time and circumstances. For example, you don’t want to risk a market downturn just as you’re leaving the workplace for good, even if it would be financially feasible. Therefore, you may adjust your portfolio to be more conservative to spare yourself some emotional hardship. Conversely, if you get that big raise, you may decide your risk tolerance ihas increased. That money is pretty much extra compared to what you had been making, so you decide that you’d rather be a bit more aggressive with it, all while staying within the confines of your risk capacity.

The Emotional Factor

In the big picture, risk tolerance and risk capacity overlap in many areas, though with your risk capacity advising your risk tolerance and not the other way around. If we let our tolerances dictate our capacity, chaos can ensue. Whether it be through exhilaration or alarm, many Americans unnecessarily buy or sell with disastrous results, ignoring their capacities and relying on their ‘gut’, or, in other words, letting current events manipulate their tolerances.

In Conclusion

The traditional factors that help define your overall risk are as follows: risk capacity and tolerance, investment horizon, age, income, net worth, and liquidity. These factors together allow you to create concrete plans that can be easily altered if one factor deviates from the previous norm. Consulting with us here at Walters Strategic Advisors is a great way to focus on your risk capacity relative to your unique financial situation rather than your gullible tolerance. We can create a goals-based plan that focuses on long-term financial success, carefully adjusted based on risk factors and historical precedents. Click the button below to schedule a meeting to determine your true risk capacity and tolerance.

About the Author

  • Douglas Walters

    Doug is the Managing Partner of Walters Strategic Partners, LLC, a licensed Registered Investment Advisory firm. Doug is a licensed Certified Public Accountant (CPA) in the state of Florida and holds a Series 65 Investment Advisor Representative securities license. He is also a member of the AICPA. With over 28 years of experience as a CPA, he believes investment decisions should be based on decades of peer-reviewed research rather than relying on the latest “hot tip” from media outlets. This empirical evidence puts the science of investing to work for his clients.