What is the difference between risk capacity and risk tolerance?
Posted by: Arti Bhargava on Feb 06, 2017, 06.30 AM IST
Saurabh is a senior partner in a architecture firm. Though young, he has bought insurance covers and started investing for his future goals. He has approached a financial adviser to plan for his future in a more holistic manner. However, he is not familiar with financial terminology. His adviser has given him a long questionnaire to fill up. Saurabh has been told that this will help the adviser assess his risk-taking capacity and risk tolerance and suggest investment options accordingly. Saurabh is perplexed, because to him, they both mean the same thing.
Saurabh may be using these terms interchangeably as they denote an attitude towards risk. However, in financial parlance, risk capacity is not just a fancy synonym for risk tolerance. Risk tolerance is the amount of risk Saurabh might WANT to take. Risk capacity, on the other hand, is the amount of risk he CAN take. Risk tolerance will be a subjective measurement of his attitude toward risk, his willingness to accept potential investment loss. He will have a lower risk tolerance if he is not comfortable with market volatility and uncertainty.
Risk capacity, however, is a function of Saurabh’s actual ability to take risk. As someone who is several decades away from retirement, he has a greater risk capacity than someone who is only a couple of years from retirement. As a high net worth individual, he has a greater risk capacity than someone with very limited funds. So risk capacity has to do with the amount of risk he can afford to take. This would be assessed using questions such as ‘Would a 20% market downturn affect you dramatically?’ Or ‘Do you have enough funds that you could survive such a dip?’ Or, ‘Do you have enough time to recover from such a dip, before you’ll need to access the funds?’
Risk tolerance is the emotional or psychological willingness to take risk, while risk capacity is his ability to take risk, without jeopardising his financial goals. Saurabh must differentiate between both because his risk tolerance and risk capacity are not the same. The predicament is that even though he has a higher risk capacity, his risk tolerance is low. This might lead to a shortfall while saving for his future goals.
(The content on this page is courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta.) This article appeared in Economic Times dated Feb 06, 2017, 06.30 AM IST