What is Risk Capacity?
We’ve talked about risk tolerance (the amount of risk you are willing to take) in our last blog, but then there is risk capacity, which is the amount of risk that you are able to take. And while these two terms sound very similar, they are very different.
Risk capacity is the amount of risk that you are able to take. The risk you are able to take may be very different than the risk you are willing to take.
You may want to achieve the highest returns possible and are willing to accept the high risk that comes along with it (this would be considered having a high-risk tolerance), but if you have things in your life that require a little bit of stability, you might not be able to be as aggressive in your investments as you would like.
Measuring Your Capacity for Risk
The maximum amount of risk you can take will depend on a number of things like your time horizon, goals, and responsibilities.
Your Time Horizon
First of all, what is your time horizon for holding on to these investments? Do you need the money in the next five years, or are you stashing it away for retirement 30 years from now?
Maybe retirement is still far off, and you can take on some riskier investments that are likely to yield higher returns. But maybe you also want to buy a house in the next three years, so that tactic wouldn’t be best for the money you save for a down payment.
If you plan to use the money soon, you may not want to invest it. Parking it in a HYSA may be your best option.
Your Financial Goals
It is really difficult to save (and invest) when we don’t know what we are saving for, which is why I am all about setting intentions for your money. Why do you want to save and invest? Of course, retirement is a common goal, but maybe you want to buy a house or pay for your child’s education.
Whatever your goals are, set a dollar value to it and then figure out how long it’ll take you to get there. Remember how we just talked about our time horizon affecting our risk capacity? Well, our goals are very similar. Knowing how short or long-term some of these goals are will affect how much risk you are able to take. Short-term goals? You may want to stick to low-risk investments or put it in a HYSA. Long-term goals? You may be more willing and able to dive into higher-risk assets.
Know the timeline associated with each of your financial goals so you can determine how much risk you can and should take to achieve them.
Here is an example of some goals. The ones highlighted are medium to long term goals and those funds could potentially be invested.
Your Personal Situation
If you are a single 25-year-old renting an apartment with no children, your risk capacity will be very different than that of someone who is 50 with a mortgage, spouse, and children.
Having a family that depends on you financially (children, stay-at-home spouse, and/or parents) affects your investment strategy. You might not want to put all of your money into the riskiest or even the most conservative investments.
Know and Trust Yourself
Only you can know what’s going to feel good for you. We aren’t feeling-less robots! While it tends to be normal and also very okay to have riskier investments for long-term goals, you still might not have the capacity (or stomach) to do so, and that’s okay!
If you have a super low-risk capacity, it’s much better to play it a little more conservatively when it comes to investing than to avoid investing altogether.
Wrapping Up
You want to have a plan for your money and know how much of it should be in low-risk investments and how much should be in high-risk investments. Consider your emotions and feelings about handling market highs and lows, look at your age, goals, and your situation, and then plan accordingly.
Want to dive deeper into risk tolerance, risk capacity, and crafting your own portfolio? Check out my Investing & Retirement course! I walk through in-depth how to craft the perfect investment portfolio for your individual, unique situation.
