What is the difference between risk tolerance and risk capacity?

Risk tolerance and risk capacity are two concepts that need to be understood clearly before making investment decisions for yourself or for a client. Together, the two help to determine the amount of risk that should be taken in a portfolio of investments.

Risk Tolerance

Risk tolerance is the amount of risk that an investor is comfortable taking, or the degree of uncertainty that an investor is able to handle. Risk tolerance often varies with age, income and financial goals. It can be determined by many methods, including questionnaires designed to reveal the level at which an investor can invest, but still be able to sleep at night.

Risk Capacity

Risk capacity, unlike tolerance, is the amount of risk that the investor “must” take in order to reach financial goals. The rate of return necessary to reach these goals can be estimated by examining time frames and income requirements. Then, rate of return information can be used to help the investor decide upon the types of investments to engage in and, the level of risk to take on.

This question was answered by Ayton MacEachern via Investopedia (http://www.investopedia.com)

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