3 days ago
How much risk can you take when investing? Know the difference between your risk tolerance and risk capacity
Siddharth Mehta, a young lawyer and senior partner in a top law firm, has taken insurance and has started investing for his goals. Seeking a comprehensive plan, he has consulted a financial adviser. However, he's confused by a lengthy questionnaire assessing both his risk-taking capacity and risk tolerance— terms that sound identical to him. What should he do?
Siddharth Mehta may be confused because both
risk tolerance
and risk-taking capacity relate to risk. However, in financial terms, they are not the same. Risk tolerance is a subjective measure. It reflects how much risk Mehta is willing to take and his comfort with potential losses and market volatility.
Risk capacity
, in contrast, is an objective evaluation of how much risk he can afford to take, based on his income,
expenses
and
financial goals
.
Risk-taking capacity is Mehta's actual ability to take on financial risk. Since he is decades away from retirement, his risk capacity is higher than someone nearing retirement. Similarly, a high-net-worth individual has greater risk capacity than someone with limited resources. That's about how much risk he can afford to take, not just what he's comfortable with. This is assessed through questions like, 'Would a 20% market dip seriously hit your finances?' 'Do you have sufficient reserves to withstand it?' 'Do you have enough time to recover before needing the funds?'
by Taboola
by Taboola
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Risk tolerance is the emotional or psychological willingness to take risk, while risk capacity is the ability to take risk without jeopardising financial goals. Mehta may have the tolerance for risk but not the capacity—or vice versa.
Content on this page is courtesy Centre for Investment Education and Learning (CIEL).
Contributions by Girija Gadre, Arti Bhargava, and Labdhi Mehta.
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