Risk tolerance is simple to explain but an extremely important metric to understand before you venture into any serious investing. Risk tolerance is not based on numbers, it is instead based on your personal feelings and ability to handle the stress that can result from taking risks. The market can be hard to predict and volatile, with roller coaster highs and lows occurring when you least expect it. If the very idea of your investment worth plummeting 20% overnight makes you angry, significantly raises your stress level, or would drive you to sell in a panic, then your risk tolerance is said to be low. A high risk tolerance means you can accept a deeper level of variations and fluctuations without an issue. In general, those with a higher risk tolerance are going to risk more of their portfolio as they try to strike a balance between risk and reward that feels comfortable to them.
Risk capacity is another term that is essential to understand before you begin wading into any investing. Your risk capacity is the maximum limit of risk you are able to take in order to meet your goals when financial planning. Anything above this number and it could have a dramatic effect on your entire portfolio or future goals. The popular saying of “Never bet more than you are willing to lose” is a prime example of risk capacity in action. If you cannot afford to lose more than $50,000, then that is your risk capacity. Most individuals and even businesses will not risk their entire capacity at a time. It is common to include a buffer of excess as part of a sound investment strategy, which leads into the next term, risk appetite.
Risk appetite is too often used interchangeably with risk tolerance, despite having starkly different meanings. The primary difference between risk appetite and risk tolerance is that appetite is based on willingness, and tolerance is based on ability. Risk appetite can easily be defined on how much you are willing to risk at any point in time. It is typically lower than your overall risk capacity in order to provide a safety net in the event of unforeseen occurrences. Risk tolerance is only related to how well you can handle losses and negative outcomes from your financial investments.
If you are considering venturing into investing to help you reach your future goals, each of these three terms will be integral to the financial planning process. Any sound investment strategy will take all of these factors into consideration. Coming prepared to your initial meeting will speed up the process and give you the confidence you need to seek out your goals. For financial, retirement, and estate planning assistance, contact BD Financial Concepts today.
Risk is one of the most common words associated with investing as part of financial planning. To some people, the very idea of taking risks with their money is unacceptable and brings on anxiety. Those individuals prefer building their money extremely slowly but relatively safely over time through only the most traditional ways, such as building interest from a bank account. To others, there is no real reward without risk, and so they choose, carefully or less so, the best options to further their personal and financial goals.
Everyone exists somewhere along this broad spectrum of risk and knowing where you lie can help your financial advisor determine the best route forward for you when you seek to build or increase your wealth. Of course, if you are just starting out, you may not be knowledgeable of common industry terms. So here is a rundown to help you present your plan with confidence at your next meeting.