- Risk tolerance represents an attempt to measure our psychological and emotional ability to handle risk. This is typically used in the context of building out an asset allocation for an investment portfolio. Our risk tolerance generally speaks to how much volatility we can handle in our portfolio without raising our blood pressure or causing us to lose sleep at night.
Many financial advisors push clients to increase the risk level in their portfolios to the maximum level the client's tolerance can handle. This is akin to hanging over the edge of the Grand Canyon for the best view. You can do it, but why would you? Standing 2-3 steps back from the ledge still gives you a great view without putting you in harm's way. Similarly, why not take a few steps back from your maximum risk tolerance and avoid the risk of falling off the cliff? In portfolio terms falling off the cliff is selling during a market downturn and locking in losses.
Anyone who has been tempted or has actually sold a portfolio that was dropping because they couldn't bear to see if go down any more understands risk tolerance. It is the inability to psychologically handle the volatility of a portfolio.
- Risk capacity measures the impact that risk has on the overall plan. Professor Wade Pfau says "Risk capacity is the ability to endure a decline in portfolio value without experiencing a substantial decline to the standard of living." I'll put it more simply - Risk capacity measures whether the risk you are taking can hurt you financially - can it possibly prevent you from achieving your financial goals?
For example, if you invest $50,000 that is needed as a down payment on a house to be purchased in two years in a portfolio with aggressive risk, there is a real chance of a market decline, leaving you with less than $50,000. You cannot now bu the house. You did not have the capacity (financial ability) to bear that risk.
Just because you are comfortable taking a level of risk doesn't mean you should. Advisors need to evaluate both risk tolerance and risk capacity before making recommendations to clients.
Considering risk as the chance or likelihood of not achieving the desired outcome, this challenges the conventional discussions concerning risk. If a client needs to have their wealth last for a 30+ years across their retirement income planning horizon, leaving money in low interest yielding CD's feels safe in the short term, but is risky in the long term. Unless there is an abundance of wealth, most retirees will need to generate real (after inflation) returns on their wealth to meet their spending goals.