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Investing is one of the best ways to build wealth, especially considering the fact that your money loses value due to inflation if you only hide your money in a savings account. . But every investor should be prepared to manage a certain level of risk when placing their money in the market. Just as there is the potential for huge gains, there is also the potential for huge losses.
That is why it is important for investors, especially new ones, to familiarize themselves with their risk capacity before choosing investments. Below, Select details what you need to know about risk capacity and how to determine yours.
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Risk capacity vs risk tolerance
Risk tolerance and risk capacity sort of sound the same thing, but the two terms should not be confused as being interchangeable. Your risk tolerance is your personal ability to comfortably bear losses. It’s more closely related to emotion. Let’s say you are extremely stressed during market downturns and still consider selling your investments during those times – this can be an indicator that you have a lower tolerance for risk.
You can also think of risk tolerance in terms of the comfort of having a guaranteed result versus a random result. For example, would you prefer $ 1,000 in cash now or a 50% chance of winning $ 5,000 in the future? If you prefer to receive $ 1,000 now, this could indicate a lower tolerance for risk due to your preference for a guaranteed outcome despite missing out on the chance to win a larger amount.
But if you choose the chance to win $ 5,000, it could indicate a higher tolerance for risk, since you are willing to take the risk of potentially winning nothing for the chance to win more.
Risk capacity, however, can be viewed from a more objective perspective. This is the level of risk you can tolerate depending on your age, how long you plan to stay invested and even your personal situation.
So while risk tolerance is based on your feelings, risk capacity views your current situation as an indicator of how much loss you can comfortably handle. For this reason, you may have a high risk capacity but a low tolerance for risk, or vice versa.
Determine your risk capacity
When it comes to determining your risk capacity, you will need to look at your current situation and consider your goals against your investment time horizon.
If you invest with the target to retire at 65, younger people will have a longer time horizon, which means their money can stay in the market much longer and have a better chance of recovering from any decline before they are ready to make withdrawals. As a result, the younger you are, the higher your risk capacity tends to be.
But let’s say you invest for a specific goal – like paying for a wedding or finally taking your dream vacation – that you want to accomplish over the next five years. Because you plan to start making withdrawals in five years, your money has less time to weather big weather declines. So you may want to take less risk with this money while still allowing it to grow in the market. This is a case where your time horizon may impact your risk capacity.
Income and expenses can also affect the level of risk you can take when making investments. A person with higher expenses and lower disposable income may not be able to make riskier investments because their money might be needed for another more urgent priority, such as building an emergency fund for an unexpected expense.
But someone with lower expenses or higher disposable income might have a higher risk capacity because they will have the ability to accept riskier investments while having a cash safety net.
Certain personal circumstances can also affect your ability to take risks. If you care about your family, you will probably want to make safer investments so that your money is not subject to as much volatility and you are more likely to be able to pull yourself out of a comfortable balance when needed.
But if you still don’t know what your risk capacity looks like or what investments would best match your risk capacity and risk tolerance, robo-advisers, like those offered by Improvement and Wealth front – can really help you orient yourself towards the right assets.
When you open a robo-advisor account, you will complete a questionnaire that will assess your risk tolerance and capacity, and then automatically create your portfolio based on this information. This will also rebalance it over time to align it with your goals and any changes in the level of risk you wish to take.
At the end of the line
Your risk tolerance and your ability to risk go hand in hand when it comes to determining how you should invest your money. These factors are different for everyone, so it is important to consider your own financial situation before going ahead with an investment strategy.
And while robo-advisors can help you determine which investments best suit your needs, always consider seeking advice from a financial professional to more adequately define the smartest approach for your money.
Editorial note: Any opinions, analysis, criticism or recommendations expressed in this article are the sole responsibility of the editorial staff of Select and have not been reviewed, endorsed or otherwise approved by any third party.