Risk capacity is defined by the amount of risk an investor can take depending on their financial and investment profile, in order to achieve their financial and investment goals. Being able to define your risk capacity is of the utmost importance so that you can take risks that are appropriate for your profile. Risk capacity should also take into account any investor’s financial goals. If an investor has high financial goals, his risk profile might be shaped in order to achieve those goals.
Risk tolerance is defined by your personality and your risk appetite. Risk capacity on the other hand is defined by your financial ability to take risks. It is dependent not only on your financial situation but also on your investment goals. Being able to adjust your risk tolerance to achieve your investment goals is also important.
However, risk capacity should influence and shape your risk tolerance. Every investor has different financial goals they want to achieve. It is important to know exactly what objectives you have, and how you can invest to achieve them. Knowing this will allow you to define your risk profile.
What influences risk capacity?
There are several factors that influence risk capacity, including your portfolio size, income, financial situation, age, financial goals, and investment horizon. Although some of these factors are also considered when evaluating your risk tolerance, they should also be considered when assessing your risk capacity. Both age and income are inherently related to risk tolerance, but they can also influence your financial situation. Thus, they should also be considered when determining your risk profile.
The investment horizon can also greatly influence the risks an investor can take. Two investors with the same portfolio size, the same income, and the same risk tolerance might make entirely different investment decisions based on their investment horizons. If your investment horizon is short, you might want to avoid any risks. Conversely, a longer investment horizon allows investors to take considerably more risk.
An investor’s portfolio size is a great influence on the amount of risk that should be taken. While the portfolio size on its own does not tell us much, it is important to combine it with the other factors influencing risk. Portfolio size is also crucial for the next factor which is financial goals.
Being able to adapt your risk-taking to the financial goals you want to achieve is an important step. When you combine all these factors influencing risk capacity, you should always consider them with your financial goals in mind. Portfolio size is particularly important when considering your financial goals. If you are close to achieving them you might want to avoid some risks. On the other hand, if you are still trying to achieve your financial goals, you can take more risks.
Your financial situation should also be considered. How much of your income are you saving? Do you have any debt? These factors will also determine your risk profile, and your ability to willingly take additional risks. There are factors that are directly related to your financial situation, that should also be considered: income and age.
This is perhaps one of the most important aspects of defining risk capacity. An investor with stable sources of income that tends to be consistent over time is able to make riskier investment decisions, than an individual who might have non-recurring income. This should be a defining characteristic of your risk capacity.
Whether we like it or not, age plays a big role in investment decisions and risk. If you are a younger investor your risk capacity is much higher than an older individual. Although this is self-explanatory, it also is dependent on the investment horizon. Age can be extremely impactful on risk. A younger individual will be able to take increasingly more risks, and older investors should try to avoid it at all costs.
High-risk or low-risk capacity
Depending on the factors mentioned above, your risk capacity might be high or low. This will have a direct impact on your investments, and your returns. Although risk tolerance is intrinsic to each investor, risk capacity might change if your financial situation improves or deteriorates. Therefore, it might change during different time periods. It is also important to note that high-risk capacity often leads to wealth creation. Low-risk capacity is more focused on capital preservation, and the ability to make safe and secure investments that avoid risks and volatility.
As an investor, you have to make sure that you can define your risk capacity. This will allow you to backtest your investment decisions and make sure they are in line with your goals, and financial situation. Some investors end up making investment decisions in the spur of the moment, and this could lead to a lot of disappointment. It is crucial that as an investor you take some time to plan your investments according to your risk profile.
Image source: PM