Risk tolerance versus risk capacity – and why it pays to know the difference
When you first meet with a financial advisor, they will ask you some questions about your risk tolerance. They will want to understand how comfortable you would be with market volatility and how you might react to seeing your investments drop in value. They will want to know if you are someone who embraces investment risk because it opens the door to more opportunity, or if you’re more risk averse – and likely to lose sleep when the market loses ground.
Risk tolerance relates to your willingness to take on risk to achieve your goals. It’s based on your beliefs, your personality and your investment experience. Think of it as your mental and emotional ability to handle the impact of possible investment losses. But is your risk tolerance in line with your financial ability to withstand those losses? This is a different question. It has to do with your risk capacity.
Risk capacity is not based on your feelings about risk. It’s not even based on any specific investment. Instead, it relates to how much risk you can afford to take. And that has to do with your financial situation, as well as your age and the time you have to invest.
When assessing your capacity for risk, ask yourself: “Is time on my side? Do I have many years to invest? Or will I need to take money out of my investment account soon?” Over time, markets generally recover from losses and the number of positive years far outweighs the negative, so your ability to remain invested during down markets is a key consideration. When making investment decisions, consider your overall financial situation and how well you can withstand any losses. If you are able to save a lot of your income each year, or you have more wealth available to you from other sources, you can better weather any downturn in the market as you pursue higher potential returns.
Hana and Haysam have identical incomes. Both are age 45. Both plan to retire in 20 years. But that’s where the similarities end. One of these two investors has a much higher risk capacity.
Hana lives alone, has no debt and no dependents. Thanks to a good job and a good company pension, she is on track to reach her savings goal for retirement. She has already paid off her mortgage and has an emergency fund. Her next savings goal is for travel. Even if she has a lower risk tolerance personally, Hana clearly has a high risk capacity. She has no immediate need to access funds from her investments. And, if she chooses investments with higher risk and higher growth potential, she could benefit financially from putting some of her risk capacity to work.
Haysam is a risk-taker by nature. He spent his emergency savings to start his own business. He is the primary income earner in a family of five. Two of his three children will be heading off to university over the next three years. Haysam has paid down half of his mortgage and has some retirement savings, but he has no pension. With more financial obligations than Hana and less money saved, his capacity for risk is lower – despite his higher personal tolerance for risk.
When investing, ideally your risk tolerance is in line with your risk capacity. If not, you may take on more risk than you can afford – or sit in safety to such a degree that your savings grow too slowly. Either way, you may find it more challenging to reach your financial goals.
That’s why it’s important to understand your own unique approach to risk and how it affects you. Investors often find that working with an advisor helps them achieve an objective and accurate understanding of their financial position. This is essential to making a well-informed decision that considers both risk tolerance and risk capacity.
To begin thinking about your risk capacity, read the following statements and rate how much they apply to you on a scale of 1 to 3.
If you answered “false” to any of these questions, the impact of investment losses may be larger for you than for other people. This means your risk capacity will be lower. The more “true” answers for you, the higher your risk capacity. Of course, this is only a general indicator of your financial ability to withstand investment losses. To learn more, talk to your advisor.
This has been provided by RBC Global Asset Management Inc. (RBC GAM) and is for informational purposes only. It is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice.
® / ™ Trademark(s) of Royal Bank of Canada. Used under licence. © RBC Global Asset Management Inc. 2019