Your Tolerance for Risk

Having a tolerance for risk is not the same as having the capacity for risk. Let's take a look at the difference between the two, because getting this wrong could prove expensive!

In a previous article, I took a look at risk versus return. We saw that if you need a higher return on your investments in order to meet your financial goal, you may have to take more risk. How comfortable are you with taking risks when investing?

Most investment advisers will measure your 'Risk Tolerance' to gauge your comfort level. However, that leaves out an important consideration. To understand what this is, consider this analogy:

You want your 12 year old son to learn to skateboard. He is not enthused about the idea, but your mother wants to try. Your son has a low risk tolerance, while it appears that your mother is comfortable with a higher level of risk. Do you offer the skateboard to your mother? No, you are aware that although your son will bounce when he hits the ground, your mother certainly won't. Her capacity for the risks of skateboarding is lower than your son's. In this example, you feel your son should take more risk than he is comfortable with to achieve the goal, while you would want to dissuade your mother from this venture despite her stated willingness to try.

Risk tolerance is how much risk you choose to take. Risk capacity is how much risk you can afford to take. A financial planner must be aware of this distinction when working with clients. His/her responsibility is to help bring the risk required, the risk tolerance, and the capacity for risk into alignment. In the end of course, it's the client's decision, but it needs to be an informed decision. Things end badly when the 'trade-offs' aren't identified or explained properly, and the client eventually says "If I had understood, I wouldn't have taken the advice."

Many 'risk tolerance' questionnaires do not work because they fail to distinguish between risk tolerance and capacity. If you would like to learn your personal Risk Tolerance,using my preferred provider, FinaMetrica, call (408) 725-7135 or click here.

Return to Free Info