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What Is The Difference Between Risk Tolerance And Risk Capacity?

What Is The Difference Between Risk Tolerance And Risk Capacity?

  • By Saral Credit
  • July 04, 2022

Risk is a potential element involved when it comes to gaining something. For a few investors, the risk of loss does not sway the potential to gain something. However, few investors feel that potential losses influence their potential to invest in a particular platform.

When planning an investment, you are asked to create a comprehensive risk profile that determines your ability to handle losses. Additionally, your risk profile helps investigate the best investments that help you achieve financial goals without losing.

The risk profile combines two major factors- risk tolerance and risk capacity. The majority of investors tend to misunderstand the terms and club them together. But they are vastly different! Risk capacity and risk tolerance majorly influence your profile design. If you are unaware of the concept, then this article is right for you!

Risk Capacity

Risk capacity is a calculated risk that the investor must take up to achieve financial goals. Risk capacity can be relevantly measured by estimating and examining the time duration and income required. The rate of return helps investors determine the risk level and the right investment type to engage in.

Risk capacity is based on how you frame your financial portfolio. It calculates the change in investment that will impact you in the long run. Factors that influence your risk capacity are;

  • Your net worth
  • Total income
  • Percentage of liquid assets available currently
  • Assets labelled in your portfolio. It includes the current value of assets, volatility, and liquidity relative to each other
  • Financial dependants
  • Financial liabilities, loans, and debts
  • Investment timeline that figures the time frame when you can withdraw cash

Risk capacity varies with income, assets and liabilities, dependants, investment strategies, and investment purposes. It answers your question about how robust and resilient your current financial condition is!

Calculation of Risk Capacity

Risk capacity is calculated using a ratio of overall wealth and investible assets.

Overall wealth includes net value on the balance sheet (assets+ liabilities) added to net future cash flow.

Investable assets include assets that the investor willingly invests in their diversified portfolio.

Risk Tolerance

Risk tolerance is the amount of risk an investor is comfortable handling. An investor's risk tolerance varies with financial goals, income, age, and business market environment. When the market fluctuates, it depends on personal calculations, gut feelings, and emotional decisions.

The investor has to closely study market fluctuations and take financial advice from experts before accepting risk.  Financial advisors help you figure out long-term and short-term challenges in a particular type of investment. Accordingly, you can adjust your fiscal goals and adjust to risk tolerance over time.

Risk tolerance is psychological. It is all about investors’ mental attitudes and personal market behaviour. His risk tolerance is calculated depending on an individual’s financial handling capacity. If an individual sleeps peacefully at night, without panic, and does not sell any investments, then his tolerance is higher than vice versa.

Balancing Risk Tolerance and Risk Capacity

Risk tolerance and risk capacity are not the same. When the risk exceeds the comfort level, it creates a financial shortfall that affects financial goals. However, on the other hand, when the level of risk tolerance is higher, the investor might willingly take up the challenge. These types of investors are termed “Risk tolerant”.

Analyzing risk tolerance requires self-assessment along with financial planning. There are times when risk tolerance and risk capacity overlap each other. Sometimes investors feel comfortable taking risks more than they can afford.

What is Right?

An individual takes financial decisions after analyzing their monetary and personal situation. At times the individual misunderstands his risk tolerance and takes up higher challenges. A financial advisor analyses your condition, calculates your risk tolerance and advice on how many challenges you can deal with.

For example, if an individual takes up higher risks, the chances are that they make bad decisions. They might face major downtime and leave the market during the worst times. Financial advisors likely suggest remaining conservative and opting for lower risk than risking your investment portfolio. This way, the person can stay in business and conquer the downtime market when everyone loses.

It should also be understood that a person with a high-risk capacity may not have the resilience to tolerate higher risk. For example, Investor A, whose net worth is 70 crores, may willingly take a 20% risk on portfolio depreciation. On the other hand, investor B, whose net worth is 30 lakhs, may take up 50% risk on portfolio depreciation. So, how will we judge both investors?

This explains that A has higher risk capacity but lower tolerance, whereas B has lower capacity but willingly accepts higher risks.

Risk is not just the potential loss of principal but also the prospect of losing upside gain from an investment. Before taking a financial decision, you must use all sorts of metrics to calculate your risk tolerance. That includes upside-downside ratio, standard deviation, fluctuating market conditions, etc. This describes how an investment varies, whether or not your investment is worthy or will you lose your night’s sleep because of higher risk.