Key takeaways:

• Risk refers to the possibility of your investments performing below your expectations. Different investments carry different levels of risk.
• Your risk tolerance is how much risk you are willing to bear when it comes to investing. It involves understanding how you might respond to drastic swings in the market and your ability to stick to a plan during challenging periods.
• Your risk capacity is how much risk you can afford to take on. It’s based on factors such as your financial situation and how much time you have to invest.
• You are more likely to stay invested when you find the level of risk that’s right for you.

From stocks to bonds, and everything in between – every investment comes with some level of risk. Risk refers to the possibility of your investments not performing in the way you expect them to. To some, that means losing money when the price of an investment changes. To others, it’s seeing your investment lose purchasing power because of inflation. No matter what risk may look like to you, it will play an important role in your investment decisions. Before you start investing, it is helpful to ask yourself some questions about risk.

First, you will want to understand your tolerance for risk. For example:

• How comfortable would you be with market volatility?
• How might you react to seeing your investments drop in value?
• Are you someone who embraces investment risk because it opens the door to more opportunity, or are you more risk averse – and likely to lose sleep when the market loses ground?

How risk tolerance changes the way you invest

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 possible investment losses.

For example, if you are more comfortable with risk-, you may choose investments that offer faster growth and higher potential returns – even if it means your holdings may lose value at times. If you’re a risk-averse investor, the opposite is true. You would opt for investments that aim to ‘defend’ your investments against losses – even if it means you could potentially see lower returns.

Risk: Defensive Assets vs. Growth Assets

How risk capacity changes the way you invest

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.

It is important to ask yourself how potential losses would affect your ability to reach your financial goals. For example:

• Are you saving for your child’s education? How many years before they finish high school? Will you have time to make up any losses if you take more risk as an investor?
• Are you close to retiring? How much have you saved? How will it affect your plans if your retirement fund drops 5 or 10% in value before you retire?
• Is time on your side? Do you have many years to invest? Or will you need to take money out of your investment account soon?

Why time is an important consideration for risk capacity

The chart below shows the worst annualized returns of three different investment portfolios over different time periods: Conservative (low risk), Balanced (medium risk), and Aggressive Growth (high risk).

A longer time horizon has reduced the likelihood of poor outcomes. Worst annualized return of representative portfolios over various time periods

Source: Morningstar, RBC GAM. For the period of January 1, 1988 to May 31, 2022. Performance based on GAM's strategic asset mix for conservative, balanced and aggressive growth global investors. Returns calculated using the following allocations, rebalanced monthly. Conservative - 58% Fixed income: FTSE Canada Universe, 2% Cash: FTSE Canada 30-day T-bill, 13% Cdn Equity: S&P/TSX Composite TR, 15% US Equity: S&P 500 TR CAD, 12% Int'l Equity: MSCI EAFE GR CAD. Balanced - 38% Fixed income: FTSE Canada Universe, 2% Cash: FTSE Canada 30-day T-bill, 15% Cdn Equity: S&P/TSX Composite TR, 25% US Equity: S&P 500 TR CAD, 15% Int'l Equity: MSCI EAFE GR CAD, 5% EM Equity: MSCI EM GR CAD. Aggressive Growth - 2% Cash: FTSE Canada 30-day T-bill, 29% Cdn Equity: S&P/TSX Composite TR, 38% US Equity: S&P 500 TR CAD, 20% Int'l Equity: MSCI EAFE GR CAD, 11% EM Equity: MSCI EM GR CAD. An investment cannot be made directly into an index. The graph does not reflect transaction costs, investment management fees or taxes. If such costs and fees were reflected, returns would be lower. Past performance is not a guarantee of future results.

• The longer you have to invest, the more time you have to make up for any losses along the way. Over time, markets generally recover from losses. Looking to the right-hand side of chart, you can see that over 30 years, even the worst return of a high-risk portfolio was 8.3% annualized. That’s good news if you have a long-term goal you’re saving for, such as retirement. This means you have a larger capacity to take on risk in your portfolio.
• But, you may not be able to tolerate that level of day-to-day movement even if your financial situation and time horizon say you can. You might still opt for a lower-risk option that matches your tolerance.
• The opposite is true if you have a shorter time to invest. Now let’s say you have a nearer-term goal of buying a home in the next year. You now have less time to make up for any losses and so cannot afford to see a 12% drop in your investments, let alone an over 30% drop.
• In this case, your risk capacity dictates that you may want to opt for more conservative, low-risk investments - even if you think you could handle the emotions that come with losses.

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.

Look for the right balance

Ideally the investments you choose are in line with your risk tolerance and 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.