What is Risk Tolerance and Risk Capacity?
What is the Risk? It is nicely summed up by Sir Warren Buffet in above quote. The risk is not knowing what we are doing. It’s something in our control. If we know what we are doing, believe me, there is no risk involved at all.
A lot of people says that Derivative trading is risky, some even says Derivative trading is a double edge sword. If derivative trading is such a risky product then why some of my friends are dealing with it and making money as good as their salary. They are able to do it because they invest enough of their time and money to understand mechanics of derivative trading. For them, Derivative is a tricky product which requires much of strategic planning and execution to make this product not much risky at all. Such a learning makes them comfortable to deal with such a product, which is deemed as risky by many, because they know what they are doing. Through their learning they improve their Risk Tolerance, though their Risk Capacity could be kind of same as of us. I know the last sentence is little quirky and not so easy to understand to some of us. So let’s dig dipper what’s Risk Tolerance and what’s Risk Capacity. Are they same?
If we break down this term into two words then the first word should be easy to understand (thanks to Sir Warren Buffet’s quote above) so our focus is on the second word, Tolerance. As per a dictionary it is “capacity to endure pain or hardship”. So how much pain one can withstand is the meaning of Tolerance. How do you behave when the value of your investment falls. How did you behave on Aug-2015 month end when Sensex fell 1600+ points, and recently when Sensex fell 550 points the second week of Sep-16. Did you lose sleep on those nights? Your behavior on such low (and high) points of market defines your Risk Tolerance. Those who have higher risk tolerance may consider market low as an opportunity and make further investments, and sleep with more peace thinking they got stocks cheaper. Wherein those who have low-risk tolerance may get panic on such days, they loose sleep and end up selling their investment on market lows, they stay happy for non-realized profits but end up realizing losses.
Oftentimes people think they can handle more risk than they actually can. It is important to be honest with yourself when assessing your risk tolerance because you don’t want to take on more risk than you are comfortable with — the last thing that you want to do is abandon your plan or make investment decisions out of fear.
In short, Risk Tolerance is all about how much risk you can handle psychologically.
While Risk Tolerance is “How much risk one can psychologically handle?”, Risk Capacity refers to “How much risk one can handle?”. There are several factors, not limited to, to determine your Risk Capacity.
- Age: Typically a younger person can take more risk as he has more time to recover losses.
- Job: Having a safe and secure job enables one to take more risk.
- Take Home: Having more take home, more bread winner better, can take more risk.
A person just starting to earn can (and should) contribute more towards equity as he has more time to recover from losses if at all he incurs, as he has High-Risk Capacity. But for someone who is about to retire in few years may not benefit well from equity exposure if the market does not go well, as he has Low-Risk Capacity though he may have High-Risk Tolerance.
Just because you have the financial capacity to take a risk doesn’t mean that you should. And just because you have a high tolerance for risk does not mean that you are in a situation where you can take risk. It’s a delicate balancing act, so prefer to take risk somewhere in between your Risk Tolerance and Risk Capacity, to have peaceful sleep at night.
Inspiration from Investopedia Article.
Originally published at The Simple Personal Finance.