When you talk to a financial advisor, either to get advice about retiring, getting out of debt, or even how to invest, you will likely hear them use the term “risk tolerance”. In some cases, they may even give you a risk tolerance questionnaire to fill out. Higher risk tolerance means you can take more risks with your investments, which usually means higher returns. However, your risk tolerance is not the only type of risk you need to think about as you also need to think about your risk capacity.
Why Understanding Risk Tolerance Is Not Enough
Before investing, you need to decide how you will divide your portfolio to allocate enough funds for each type of investment. Your risk tolerance is just one part of helping you determine how much to put into each investment. Instead of putting too much emotion into the decision, which your risk tolerance calls for, investors are also asked to think about their capacity for risk.
Your risk capacity determines the amount of risk you can afford, in many cases the amount of money you can afford to lose in an investment. Even when a financial advisor or a questionnaire indicates that you can tolerate some level of risk (your risk tolerance), you might not have the capacity (funds) to take on that kind of risk. Risk capacity and risk tolerance are, therefore, different but intertwined.
You Should Know How Much Risk You Can Afford
As mentioned, realizing risk in investment means you can afford to lose money. Speculative investments and positions that are not diversified (where there is a larger risk of losing money) are not always a great idea for most people because their risk tolerance is not high enough.
Also, the overwhelming majority of people work to build their wealth as opposed to relying on an inheritance to have the assets to reach financial independence. This group cannot afford a total loss of their investment which means they have to gauge their risk capacity even in cases where their risk tolerance is sky-high.
Speculative bets and risky investments like cryptocurrency provide huge rewards. However, because reward and risk are tightly intertwined, the prospect of a huge reward always comes with the risk of losing part or the whole of your portfolio.
If you cannot afford to lose money in an investment, and cannot recover from such a loss, then you do not have the capacity to get into that investment option. In this case, you are advised to seek out investment opportunities better aligned with your risk capacity and tolerance.
How to Invest Better for Wealth Building
If you want to invest to build wealth, financial advisors say that a diversified stock portfolio is the best way to go. Investing for the long-term, usually decades, aligns better with most people’s risk capacity.
Also, the longer you invest, the better you will be able to handle short-term volatility and shocks as well as take advantage of compounding returns.
The next time you think about investing or diversifying your portfolio, think about your risk capacity and tolerance. They will help you get a better idea of whether you are getting into a good investment as well as help you manage risk to your portfolio and investments.