What is risk capacity and risk tolerance and how do they impact your investment strategy?
January 20, 2020
Before making an investment decision, you need to understand how your risk capacity and tolerance will affect your investment strategy.
Risk capacity is a measure of the risk you need to take to reach your financial goals, while risk tolerance considers how much risk you are comfortable taking.
These two factors will influence your investment decisions and can help develop an investment plan when you pair them with your investment return targets.
For example, some people, particularly people in small business, have high risk tolerance because they are used to taking risk and are happy to take risks. But as they get older, their capacity to recover from the downside of risk is less because they don’t have as much time to recover.
Understanding risk capacity and tolerance
Let’s say you’re a small business owner in your 30s and the market slumps for a decade — your risk capacity is higher because you still have many years to work and earn to build up your wealth before your retire.
However, it’s a different story if you’re 60, even if you’re still comfortable with taking risks.
If you’re approaching retirement age, your risk capacity is much lower compared to your younger years because you have less time to recover from a financial shock.
Investors need to understand their risk capacity and tolerance, especially when it comes to retirement planning.
Those planning for retirement should set a spending target to map out how much they anticipate spending each year and how much money they need to reach that target on time.
Investors need to find the right balance between risk capacity and risk tolerance to effectively plan for the future.
If your risk tolerance is lower than your risk capacity, then you may not make enough money from your investments and fail to reach your financial goals.
On the other hand, if your tolerance is higher than your capacity, then you may end up taking on unnecessary risk.
Get expert investment advice
Navigating the risk capacity and tolerance of your investments is difficult, which is why you should work with an expert to plan your investment strategy.
LDB Group’s experienced specialists have helped countless individuals and businesses plan their investment strategies and find the right level of risk for their situation.
If you want expert investment advice, give us a call on (03) 9875 2900 or fill in the form below.