As a financial planner, I see too many investors fail to understand the difference between 2 types of risk

As a financial planner, I see too many investors fail to understand the difference between 2 types of risk

As a financial planner, I see too many investors fail to understand the difference between 2 types of risk
Knowing how much risk you can truly afford is key. (Author is not pictured).kate_sept2004/E+/Getty
  • As a financial planner, I help clients align their goals with their ability and willingness to take on risk in investing.
  • Risk tolerance is a measure of how much risk you can withstand emotionally, while risk capacity is how much risk you can handle financially.
  • In the end, your tolerance doesn't mean much if it exceeds your capacity.

If you've ever spoken with a financial advisor — or even a robo-advisor, for that matter — about investing money, then you've probably heard of "risk tolerance" or taken a risk-tolerance questionnaire.

The higher your tolerance, conventional wisdom says, the more risk you can take with your investments. The lower your tolerance, the more conservative you may want to be with your portfolio.
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But your risk tolerance is only a measure of your emotional capacity to take risks. It tells us nothing about your actual ability to afford to realize them. For that, you need to understand your risk capacity.

Why knowing your risk tolerance isn't enough

Knowing risk tolerance is part of the process of determining how to allocate your portfolio between stocks and bonds. But many investors put far too much emphasis on their emotional reactions, rather than asking, "what is my actual capacity for risk?"

Risk capacity is your ability to afford the risks that a risk-tolerance questionnaire might suggest you can take. Capacity and tolerance are not the same things.
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Someone could score extremely high on a risk-tolerance questionnaire, which in a vacuum would suggest that they could handle a more aggressive investment portfolio. But their tolerance says nothing about whether or not they can afford to realize such risks.

Because when we're talking about investments, "realizing" risk means losing your money. Your tolerance doesn't mean much if it exceeds your capacity.

Know how much risk you can truly afford

This is why speculative investments or highly-concentrated positions are usually a bad idea for most people — even if your risk tolerance says you can handle high-risk options.
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Most people working to build their own wealth, who cannot rely on an inheritance to provide the assets they need to become financially independent, can't afford a total loss of what they contribute to an investment.

Speculative bets on market sectors, single stocks, or investments like cryptocurrencies can provide huge rewards, but risk and reward are tightly related. You don't get the prospect of hitting it big without the real possibility of losing everything.

If you can't financially recover from the kind of loss that you could reasonably expect from a particular investment, then you may not have the capacity to make it and should choose a course that's more aligned with both your risk tolerance and capacity.
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This is why investing in a globally diversified stock market portfolio over a period of decades is the chosen route for wealth building. It aligns with the average person's risk capacity, thanks in large part to the long-term nature of this strategy.

The longer you invest in the market, the more time you have to ride out potential short-term volatility and benefit from compounding returns.

The next time you think about your risk tolerance, make sure you include risk capacity as part of the equation to get the full picture on how well you're managing risk in your investments.
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Eric Roberge is a certified financial planner and the founder of Beyond Your Hammock.
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