Download the Schwab app from iTunes®Get the AppClose

  • Find a branch
To expand the menu panel use the down arrow key. Use Tab to navigate through submenu items.

Risk Tolerance vs. Risk Capacity: What’s the Difference?

Does Your Risk Tolerance Change Over Time?

What’s your likely response to a sudden 10% drop in the value of an investment? Would you sell all or some of your shares? Do nothing? Would you ever consider buying more?

Your answers to questions like these could provide important insights into your true risk tolerance, says Rob Williams, director of income planning at the Schwab Center for Financial Research.

Risk tolerance is an essential consideration when determining how to construct and maintain your portfolio over time. Unfortunately, investors aren’t always the best judges of their own appetites for risk, Rob notes.

For one thing, many people don’t consider the difference between risk tolerance and risk capacity, he says. Understanding how these two qualities differ—and how they interact in your life—can help you maintain an investment strategy that may enable you to better achieve your goals.

In the most basic sense, risk tolerance is your ability to stomach wide market swings in exchange for potential higher returns in the future.

But being able to accurately gauge your taste for risk can be tricky, Rob says. “When the market is doing well, you may think your risk tolerance is high. But when the market falls, you forget about that and your appetite for risk drops.” This is basic human nature, a phenomenon that psychologists refer to as loss aversion—the concept that losses trigger a greater emotional impact than equivalent gains.

That’s why investors often end up buying high and selling low—never a good strategy for success.

To get a better understanding of your ability to tolerate risk, it helps to look more broadly at the type of person you are. In fact, you might be surprised to learn that your risk tolerance really doesn’t change much over your lifetime, says Tyler Nunnally, U.S. strategist for FinaMetrica, which provides risk assessment tools for the financial services industry.

“Risk tolerance is a personality trait, similar to being an extrovert or an introvert,” he says.

Your risk tolerance doesn’t change much over time.

That said, a person’s risk tolerance may vary across different areas of his or her life. Risk-taking behavior is divided into different domains, and there are no correlations between them. For example, ‪‪some people who enjoy high-risk hobbies, such as skiing or rock climbing, may prefer very conservative investments. It depends on the person. ‪And risk tolerance can also vary by gender; FinaMetrica data shows that among 67% of couples, men have a higher risk tolerance than their female partners.

What does shift over time is your capacity to take on financial risk—that is, your ability to withstand a financial shock. Your risk capacity can be influenced by a variety of financial factors throughout your life, including loss of a job, saving for your children’s education or a health crisis that leads to unexpected medical bills—changes that will likely lead you to revisit both personal and financial goals and your timeline for achieving them.

Thus, it’s important to understand how your capacity and your tolerance for financial risk may interact, Rob notes.

“Can” versus “should”

A high tolerance for risk doesn’t mean you should take on more risk than necessary to achieve specific goals. Consider your time horizon. “If you have a goal of sending your kids to college, with a time horizon of 15 years or more, it’s likely that you’d have time to recover from volatility in the market—so you could take on more risk,” Rob says. “But as you move closer to your goal, your risk capacity may change because you may not have time to recover from a market drop.”

Your level of wealth could also impact your capacity for risk. It may seem obvious that the more you’ve accumulated, the more easily you could weather a downturn in your portfolio without it affecting your goals or lifestyle. And while that’s perhaps true when you still have a long time horizon, you may eventually want to think about protecting your wealth for future generations, Rob notes.

Know thyself

Charles Schwab’s Investor Profile Questionnaire can help you understand your tolerance for risk—and also guide you in determining your risk capacity when constructing a portfolio. Rob recommends revisiting the questionnaire once a year when reviewing your investments and reconsidering your asset allocation, given how your life may have changed over the past 12 months. Ask yourself whether your goals, priorities or time horizon have shifted.

Going through that exercise, you may find that you have a general level of risk tolerance but a different risk capacity for each goal.

For example, if you have an emergency fund, it’s hard to predict when you’re going to need that money—so it shouldn’t be invested aggressively, Rob says. If you’re saving for a down payment on your first home, your capacity for risk will depend on when you plan to make the purchase. In your retirement account, you should gradually reduce your risk profile as retirement nears, without eliminating risk altogether.

To manage different goals, Rob suggests dividing investments into multiple buckets with different allocations. If you’re someone who enjoys excitement in your portfolio, consider taking those extra risks in a separate account using assets that you can afford to lose, he says—in other words, where you have a greater risk capacity.

What you can do next

How well do you understand your own tolerance for risk?

To evaluate whether your risk tolerance and risk capacity are reflected in your investment plan, contact a Schwab Financial Consultant at a branch near you, or call 800-355-2162.

Is a High-Priced College Worth the Cost?
Is a High-Priced College Worth the Cost?
Does Zika pose an Olympic-sized risk to stocks?

Important disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs, and when rebalancing a non-retirement account, taxable events can be created that may affect your tax liability.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

© 2016 Charles Schwab & Co., Inc. All rights reserved. Member SIPC.

(0716-JLGE)

Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.