Risk Appetite, Risk Tolerance, and Risk Capacity – How a Financial Plan Crafts an Investment Strategy
As financial advisors, one of our primary goals is to guide you through the investing journey, ensuring that your financial decisions align with your unique circumstances and aspirations. Three pivotal concepts to understand in this context are risk appetite, risk tolerance, and risk capacity. Let's delve into these concepts to help you make informed investment decisions.
1. Risk Appetite: The Emotional Side of Risk
Risk appetite refers to the level of risk you are emotionally willing to take on to pursue your financial goals. It’s an expression of your willingness to accept the potential ups and downs in the value of your investments. This concept is inherently subjective and is influenced by various factors, including your personality, past experiences, and overall outlook on life.
To better understand your risk appetite, ask yourself:
- How do I react to market volatility? Does it keep me up at night?
- Am I comfortable seeing my portfolio value fluctuate significantly?
- What are my long-term financial goals, and how aggressively am I trying to achieve them?
By answering these questions, you can gauge your natural inclination toward risk and begin the path to understanding if you are an aggressive, moderate, or conservative investor.
Personally, my accounts are all aggressively invested. Morgan Housel said, “Every past market decline looks like an opportunity, and every future decline looks like a risk.” I genuinely believe in the innovation and growth of companies over the long term, so I consider every market decline an opportunity.
2. Risk Tolerance: The Rational Side of Risk
While risk appetite is about your emotional willingness to take on risk, risk tolerance is about your ability to endure financial loss without deviating from your investment strategy. It's a more rational assessment considering your financial situation, investment horizon, and financial goals.
Factors influencing risk tolerance include:
- Age: Younger investors generally have higher risk tolerance because they have more time to recover from potential losses.
- Income and Savings: Higher income and substantial savings can buffer against market downturns, increasing risk tolerance.
- Financial Obligations: Significant financial responsibilities, such as a mortgage or children’s education, might lower your risk tolerance.
Understanding your risk tolerance helps craft a diversified portfolio that aligns with your ability to absorb potential losses and stay the course during market turbulence.
3. Risk Capacity: The Practical Side of Risk
Risk capacity is the least subjective of the three concepts. It refers to the actual financial ability to withstand losses and still achieve your financial goals. Risk capacity is grounded in hard numbers and facts, unlike risk appetite and tolerance, which are influenced by emotions and personal circumstances.
When determining your risk capacity, consider:
- Net Worth: Your total assets minus liabilities help provide a clear picture of your financial standing.
- Income Stability: A stable and predictable income stream increases risk capacity.
- Time Horizon: The time you have to invest before accessing your money impacts your capacity to take risks. Longer horizons generally mean you have higher risk capacity.
Risk capacity is crucial because it sets realistic boundaries within which your risk appetite and tolerance can operate. Even if you have a high-risk appetite, the responsible thing to do might be to take a more conservative approach if your financial capacity is low.
I’m 41, and my wife is 39, so we still have around 20-30 years in the workforce, plus another 30 years of retirement, so our time horizon is long. We both have good incomes and are prudent savers, so this allows us to be risky with our investment allocations as we know they won’t be needed for many years.
Aligning the Three: Crafting Your Investment Strategy
Understanding the interplay between risk appetite, risk tolerance, and risk capacity is essential for developing an investment strategy that aligns with your unique profile. Combining these three elements allows you to build a resilient and adapted investment portfolio unique to you and your needs. This strategic alignment ensures you are comfortable with your investment choices and positioned well to pursue your financial goals with (hopefully) less stress.
While I touched on how I invest, I believe that investing is a profoundly personal journey, and understanding the nuances of risk appetite, risk tolerance, and risk capacity can significantly enhance your financial decision-making. At KWB, we help you navigate these complexities, ensuring that your investment strategy reflects your personal preferences and financial realities. Together, we can create a robust plan that balances your desire for growth with the need for financial security, paving the way for a brighter future.
*There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.