Understanding the Difference between Risk Tolerance and Risk Capacity

Everyone who thinks about investments of any kind will think about risk. It doesn’t apply so much in terms of opening a standard savings account, because there is no real risk involved here. However if this is the only type of investment you choose this is an indication of your attitude to risk.

Let’s take a closer look at these two references to risk to see what the difference is between them.

What is risk tolerance?

This is simply how tolerant you are to risk. If you see an investment opportunity that comes with a high degree of risk, you may not feel happy about considering it. If you have a low tolerance to risk you will avoid the riskier investments and stick with the secure ones. In contrast someone with a high risk tolerance is more likely to look into riskier stocks, shares and other types of investments.

What is risk capacity?

Some people get these two elements mixed up. Either that or they think they’re different terms for the same thing. This isn’t the case. Risk capacity is all about the capacity you have to accommodate risk. Your capacity for risk could change frequently depending on what else is going on in your life. For instance you might have a high capacity for risking your investments in the hope of earning more while you are young and single with no ties or responsibilities. Compare this to someone who is married with kids and has a home to pay for. They may well have a much lower risk capacity as a result of this situation.

Understanding where you are on the scale of each

Before considering a new investment of any kind, it is wise to consider your current position on the scale of risk capacity and risk tolerance. Both elements are fluid so while you may be open to riskier investments one year, the situation could be very different the next year. The important thing is to consider where you stand every time you are thinking of investing funds in any way, shape or form.

Of course there are situations in which you believe you have a good appetite for risk when in fact you are not as happy about it as you think you are. This is why it is best to take some time to consider your position. You can arrive at your answers and then put them to one side for a day or two before returning to them. You’ll then have a more accurate idea of how close to the truth you are.

As you can see it makes sense to discover what your own personal tolerance and capacity are for risk. This is essential information that could help you figure out whether or not you will be happy with that new investment, especially if it goes south at any point. Having the best knowledge on this area in advance means you will always have a better understanding of your appetite and capacity for risk.