A reader asks: what’s the difference between risk tolerance and risk capacity?
That’s an interesting question and it depends on who you ask. The investment industry measures risk in terms of volatility, taking the opportunity for both gains and losses into consideration.
I will answer with a focus on losses rather than gains because, for most people, risk implies the chance that they will lose money rather than make money.
Risk tolerance is your emotional capacity to withstand losses without panicking. For example, during the financial crisis of 2008 – 2009 people with a low or modest risk tolerance, who saw their investment portfolios decline by as much as 50% because they were heavily invested in stocks, sold out and did not recoup their losses when the stock market recovered. Their risk tolerance was not aligned with the risk they were taking in their portfolio. In many cases they were not aware of the risks they were taking because they had been lulled by the gains they had experienced in the prior years.
People who bought homes in the run-up to the real estate crash of 2008 were unaware of the risk they were taking because they believed that home prices would always go up. When prices plunged they were left with properties that were worth less than the mortgage they owed.
This exposed them to the issue of risk capacity.
Risk capacity is your ability to absorb losses without affecting your lifestyle. The wealthy have the capacity to lose thousands, millions, or even billions of dollars. Jeff Bezos, founder of Amazon, recently lost $6 billion dollars in a few hours when his company’s stock dropped dramatically. Despite this loss, he was still worth over $56 billion. His risk capacity is orders of magnitude greater than most people’s net worth.
The unlucky home buyer who bought a house at an inflated price using creative financing found out that the losses they faced exceeded their net worth. As a result many people lost their homes and many declared bankruptcy.
There are some new tools available to measure your risk tolerance and determine how well your portfolio is aligned with your risk number. Click HERE to get your risk number.