We all understand risk as the probability of occurrence of a bad outcome or non-occurrence of a good outcome. In the market, risk is normally measured using the variance of returns. But there are some important concepts to understand. Most investors tend to confuse between risk tolerance and risk capacity. They even use them interchangeably. Actually, they are vastly different from one another. Risk capacity and risk tolerance have major implications for the way you design your portfolio mix. Let us understand the comparison of risk capacity vs risk tolerance and also look at the difference between risk capacity and risk tolerance.
Risk tolerance is subjective; Risk capacity is objective
Why do we say that risk tolerance is subjective? That is because risk tolerance is more of an emotional representation. It has a lot to do with your mental make-up. By default, some individuals tend to panic at the first sign of risk while there are others who have the capacity to withstand any amount of risk without flinching. When the markets crash, there are some traders who panic when the stocks fall by 5% but there are still others who do not panic even when the stock is down 20%. The latter group has a much higher risk tolerance. Now the person with the higher risk tolerance in the above instance may or not have the capacity to take that kind of risk; so let us now turn to risk capacity.
Risk capacity is objective. That means, it can be defined by clear demarcations and can also be measured. For example, top ranking businessmen like Bill Gates, Mark Zuckerberg and Jeff Bezos have the capacity to take billions of dollars of risk. Mark Zuckerberg recently saw a few billions of dollars of his wealth wiped out when the privacy issue came out in the open. A few years back, Amazon lost about 10% of its market cap on profitability concerns and Jeff Bezos personally saw his fortune dwindle by about $8 billion. Eventually, Bezos ended up twice as rich. Large stock holders and investors have a huge capacity for risk; but they are normally people who never take uncalculated risks.
Risk capacity is more relevant for financial planning compared to risk tolerance
From a financial planning perspective, risk capacity is a lot more relevant than risk tolerance. You may have a tolerance for seeing 50% depreciation in your portfolio. That could be your mental make-up. But that has nothing to do with how much risk you should be taking. Risk capacity is about how much risk you are capable of taking. Your future financial plan is all about using the power of time and compounding to create an investment mix to efficiently meet your goals. As you create your portfolio and then monitor the portfolio as you go along, the driving consideration is your risk capacity. Your debt-equity mix, your liquidity composition, your focus on short term versus long term investments; will all depend on your risk capacity. When we actually talk about risk in financial planning parlance, we are referring to your risk capacity not to your risk tolerance.
A person with a high risk tolerance may not have a high risk capacity
Let us look at a quick case study of two investors. Investor A has a net worth of Rs.50 crore and he is willing to take a 10% risk of portfolio depreciation. Investor B has a net worth of Rs.30 lakhs but he is willing to take a 50% risk of portfolio depreciation. How would you judge these two investors?
Obviously, Investor A has relatively higher risk capacity but he has much lower levels of risk tolerance. In a nutshell he is a conservative investor who is more interested in preserving his capital. Investor B has a much lower risk capacity but he has a much higher risk tolerance. Therefore risk tolerance and risk capacity need not necessarily go together. In fact, more often than not, your risk tolerance and risk capacity do not go together. When you have a high risk capacity but low risk tolerance, you may end up taking lower risk than warranted and end up with sub-optimal asset allocation. If you have a low risk capacity but high risk tolerance, you would normally end up playing a dangerous game in the market.
Just because you can afford to take risk, does not you mean you should take it
As the chart above captures eloquently, you do not need to take on risks just because you have the risk capacity. Risk capacity comes from age, wealth and income levels. The people who sustain the wealth are those whose risk tolerance is way below their risk capacity. The people who actually create wealth in this world would be those who are willing to take on calculated and calibrated risks. The top right category is where most of the successful entrepreneurs, investors and industrialists will normally fall.