Risk Tolerance vs. Risk Capacity
If you’re a student of market history, you know that those who remain invested during periods of market volatility have often been rewarded. But how can you craft a portfolio that allows you to stay invested confidently during times of market turbulence? The key is developing a well-diversified strategy that aligns with your risk tolerance.
Risk tolerance refers to the level of volatility you’re comfortable with in your investment portfolio without feeling the urge to change your strategy. To earn potential gains, you need to accept some level of risk. The risk/reward matrix tells us that the more risk you take, the higher the expected return could be. But how do you determine the right level of risk for you? It’s important to consider not only how much risk you’re willing to take but also how much risk you need to take to meet your financial goals.
In contrast to risk tolerance, risk capacity refers to your financial ability to sustain a certain level of risk. For example, you may be comfortable with a 50% stocks/50% bonds portfolio, but your financial situation may require you to take on more risk—perhaps a 70% stocks/30% bonds mix—to potentially earn the higher returns necessary to support your retirement.
That said, the risk level you assign to your portfolio shouldn’t be a “set it and forget it” approach. It’s essential to periodically review your portfolio in light of your financial goals to ensure they are still aligned. Your financial picture may change, or your attitude toward risk may evolve over time.
Additionally, your portfolio’s risk level could change without you making any adjustments. For example, if your portfolio is set at 70% stocks and 30% bonds, but the stock market outperforms the bond market for a period, your stock allocation may exceed your target. This is where rebalancing comes into play. Rebalancing in this case would involve selling some of your stocks and buying bonds to return your portfolio to its target risk level.
Adjusting your risk target is one way to align your portfolio with your financial goals. However, this is just one tool in your financial strategy. By working with a financial professional, you may also explore a combination of strategies, such as adjusting your spending and saving patterns, to help you stay on track toward your goals.
Ultimately, understanding your financial picture is crucial when determining the right level of risk. At any risk level, it’s vital to ensure your portfolio is well-diversified and aligned with your financial objectives. These are key areas of focus at Heritage Wealth Architects. We work with clients to ensure they feel confident about their financial future by crafting personalized financial plans that help set the right level of risk for their success. Please feel free to reach out to our team with any questions.
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