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Investing is one of the best ways to build wealth, especially when you consider the fact that your cash loses its value to inflation if you're only stashing your money in a savings account. But every investor should be prepared to handle some amount of risk when they put their money in the market. Just as there is potential for huge gains, there is also potential for huge losses.
That's why it's important for investors, especially new ones, to get acquainted with their risk capacity before choosing investments. Below, Select breaks down what you need to know about risk capacity and how to figure out your own.
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Risk tolerance and risk capacity kind of sound the same, but the two terms shouldn't be mistaken as interchangeable. Your risk tolerance is your personal ability to comfortably stomach losses. It's more closely tied to emotion. Let's say you get extremely stressed out during market dips and always consider selling off your investments during these periods — this may be an indicator that you have a lower risk tolerance.
You can also think of risk tolerance in terms of your comfort with having a guaranteed result versus a chance outcome. For example, would you prefer $1,000 in cash right now or the 50% chance of winning $5,000 in the future? If you'd prefer to receive $1,000 right now, this could indicate a lower risk tolerance because of your preference for a guaranteed outcome despite missing out on the chance to win a larger amount.
But if you chose the chance to win $5,000, this could indicate a higher risk tolerance, since you're willing to assume the risk of potentially earning nothing for the chance at larger gains.
Risk capacity, however, can be thought of in a more objective light. It's the amount of risk you can tolerate based on your age, how long you plan to stay invested and even your personal circumstances.
So while risk tolerance is based on your feelings, risk capacity considers your current circumstances as an indicator for how much loss you can comfortably manage. Because of this, you may have a high risk capacity but a low risk tolerance, or vice versa.
When it comes to figuring out your risk capacity, you'll need to take a look at your current circumstances and consider your goals as they pertain to your time horizon for investing.
If you're investing with the goal of retiring at 65, younger people will have a a longer time horizon, which means their money can remain in the market for much longer and have a greater chance for recovering from any dips before they're ready to make withdrawals. As a result, the younger you are, the higher your risk capacity tends to be.
But let's say you're investing for a specific goal — like paying for a wedding or finally taking your dream vacation —you want to accomplish in the next five years. Because you intend to start making withdrawals in five years, your money has less time to ride weather severe dips. So you may want to take less risk with that money while still allowing it to grow in the market. This is an instance where your time horizon can impact your risk capacity.
Income and expenses may also impact how much risk you can take on when making investments. Someone who has higher expenses and less disposable income may not be able to make riskier investments since their money might be needed for another more urgent priority, like building an emergency fund for a surprise expense.
But someone with lower expenses or more disposable income could have a higher risk capacity, since they will have the ability to take on riskier investments and still have a safety net of cash.
There are also some personal circumstances that can affect your risk capacity. If you care for family, you'll likely want to make safer investments so your money isn't subject to as much volatility and it's more likely you'll be able to withdraw from a comfortable balance should the need ever arise.
But if you still aren't sure what your risk capacity looks like, or what investments would best match your risk capacity and risk tolerance, robo-advisors — like the ones offered by Betterment and Wealthfront — can actually help guide you toward the right assets.
When you open a robo-advisor account, you'll fill out a questionnaire that will asses your risk tolerance and capacity, and then automatically build your portfolio based on that info. It will also rebalance it over time to align with your goals and any changes in how much risk you want to take on.
Your risk tolerance and risk capacity go hand-in-hand when it comes to figuring out how you should invest your money. These factors are different for everyone, so it's important to consider your own financial situation before you move forward with an investing strategy.
And while robo-advisors may help you figure out which investments best align with your needs, always consider seeking advice from a financial professional in order to more adequately map out the smartest approach to your money.