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Personal Finance 101: Understanding Risk Tolerance vs Risk Capacity


risk tolerance for investing


When it comes to personal finance, the terms "risk tolerance" and "risk capacity" often come up, especially in the context of investing. While they may seem similar, they serve different purposes in your financial planning. To help you understand these concepts better, let's delve into their definitions and illustrate them with a real-life example.


What is Risk Tolerance?

Risk tolerance is the level of risk you are comfortable taking on. It's a psychological measure that gauges how much market volatility or potential loss you can handle before feeling the need to change your investment strategy. Risk tolerance varies from person to person and can be influenced by factors such as age, experience, and financial goals.


What is Risk Capacity?

On the other hand, risk capacity is the level of risk you need to take to achieve your financial objectives. Unlike risk tolerance, risk capacity is more of a financial measure. It takes into account your current financial situation, future needs, and the time horizon for your goals.


The Case of Joan

To put these concepts into perspective, let's consider a hypothetical example of a 75-year-old woman named Joan. Joan has a pension that covers all her daily expenses and financial needs. Additionally, she has a million-dollar investment portfolio.


Joan's Risk Capacity

Given that her pension and Social Security benefits cover all her necessities, Joan has a high risk capacity. She doesn't need to draw income from her million-dollar portfolio to meet her daily needs. In other words, she can afford to take on more risk in her investments because her essential expenses are already covered.


Joan's Risk Tolerance

Despite her high risk capacity, Joan prefers to keep her money in a savings account because she dislikes market volatility. This indicates that she has a low risk tolerance. She is not comfortable seeing fluctuations in her investment value, even if she can technically afford to take on more risk.


The Importance of Aligning Risk Tolerance and Risk Capacity

Joan's case illustrates that it's possible to have a high risk capacity but a low risk tolerance. The key takeaway here is that understanding both your risk tolerance and risk capacity is crucial for making informed financial decisions. Failing to align these two can result in either taking on too much risk or missing out on potential returns.




-Jeb


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