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The Difference Between Risk Tolerance and Risk Capacity

By Don Williams | March 31, 2022

The first quarter of 2022 has certainly not been boring. Geopolitical upheaval and rapid inflation along with rising interest rates have driven volatility up and, with that, questions from clients about whether to reposition portfolios defensively. So perhaps now is a good time to discuss portfolio risk in more detail.

When making investment decisions, risk tolerance and risk capacity must be clearly understood. Investopedia defines Risk Tolerance as “the amount of risk that an investor is comfortable taking or the degree of uncertainty that an investor is able to handle. Risk tolerance often varies with age, income, and financial goals. It can be determined by many methods, including questionnaires designed to reveal the level at which an investor can invest but still be able to sleep at night.” In my investment advisor capacity, I use Riskalyze to measure client risk tolerances to determine how to properly allocate their portfolio. Riskalyze is the company that invented the Risk Number®, which powers the world’s first Risk Alignment Platform and was built on top of a Nobel Prize-winning academic framework.

The second aspect of risk one needs to understand is their risk capacity. Again, from Investopedia “Risk capacity, unlike tolerance, is the amount of risk that the investor “must” take in order to reach their financial goals. The rate of return necessary to reach these goals can be estimated by examining time frames and income requirements. Then, the rate of return information can be used to help the investor decide upon the types of investments to engage in and the level of risk to take on.” As financial planner, I use eMoney to build comprehensive financial projections to identify how my client’s savings are aligning with their goals to determine the return needed to not outlive their money. Balancing these risks is not easy. As well-known financial planner Harold Evensky asks his clients “do you want to eat less well or sleep less well?”

Understanding both risk characteristics as an investor is critical and without the proper tools, it can be difficult to assess. The cost of the software alone is thousands of dollars a year. I welcome anyone to take the Riskalyze Quiz to determine their risk tolerance or to do a rudimentary financial plan with me in by completing my Fact Finder. In a volatile market environment, such as now, the peace of mind that comes from knowing your complete risk attitude may be more important than ever.

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Determining your Risk Number is important for making sure we help you invest according to your financial objectives and risk capacity.

This 5 minute quiz covers everything from portfolio size, your financial goals, to what you’re willing to risk for potential gains.

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