Why you should know the difference between your risk tolerance and risk capacity
Investing carries risk. The amount of risk you decide to take on in your investments has two components: your risk tolerance and your risk capacity. Your risk tolerance is your willingness to take risk—any risk. Your risk capacity is the amount of money you can put at risk. Together, they define your risk profile, which may be a big influence on how you invest. Let’s see how and why it’s important.
What’s risk tolerance?
Your risk tolerance describes your willingness to walk up to a roulette wheel and put money on red.
It measures your willingness to take on risk. Do you avoid risk at all costs—called risk averse—even if the potential reward is significant? Or are you risk seeking because you think the potential benefits outweigh the risks (and maybe you even enjoy the thrill)?
Your risk tolerance is a personal decision; it’s subjective. For some, it could be a personality trait—certain people are daredevils in all aspects of life, and some aren’t.
When you’re choosing investments, your risk tolerance can be influenced by a variety of factors besides your personality, including your age, income, family situation, and net worth. If rapid changes in your investments’ value would cause you to lose sleep, you may not have high risk tolerance.
What’s risk capacity?
Your risk capacity tells you whether you can afford to gamble, for example, $100, $1,000, or $100,000—are you a multimillionaire, or is that all the money you have?
Risk capacity is a more mathematical, fact-based measurement of risk, and determines your ability to take on risk. You may want to gamble on roulette, but your income and savings may tell you that you shouldn’t. Risk capacity ignores your wants—that’s your risk tolerance—and focuses on what level of risk is appropriate for you based on your situation and goals.
When it comes to investing for retirement, your risk capacity comes down to the answers to questions such as:
- How much money can you invest toward retirement?
- What are your retirement savings at this point in time?
- How long until you plan to retire?
- What rate of return must your investments earn each year to achieve your desired retirement lifestyle?
If you determine that your investments only need to earn 1% each year to achieve your retirement goals, then your risk capacity is most likely low. Why consider taking on more risk if you don’t have to? If you want to have a higher rate of return on your investments, you probably have a high risk capacity. You may need to consider investing in riskier investments to receive a higher annual return and achieve your retirement savings goal. Alternatively, you could reduce your savings goal, increase your years until retirement, or a combination of the two, to lower your risk capacity.
What happens to your risk tolerance over time?
It’s unlikely you’ll have the same risk tolerance at age 60 as you did at age 25, although, of course, it’s possible. Because time is a notable factor in your risk tolerance—the more time you have, the greater your tolerance, generally—risk tolerance usually decreases as you get older. Life events can also influence your risk tolerance—some will increase it, and others may lower it.
If you inherit a large sum of money from a loved one, your risk tolerance may increase because you’re not as concerned about losing money—you have a lot more of it now. Your risk capacity may shift in the other direction—downward—because you don’t have to take on as much risk to achieve the same outcome.
If you’re within a year of retiring and exceed your retirement savings goal, you’re likely right where you hoped you’d be. You may decide your risk tolerance is low in order to help achieve your retirement goal—no reward is worth taking on additional risk. This drop in tolerance may be the opposite of what’s happening to your capacity—you may be able to afford to take on more risk, but you prefer not to.
Where do you fall in the risk spectrum?
Risk profiles can be grouped into three general buckets: conservative, moderate, and aggressive. See which description best describes you.
Risk tolerance: your willingness to take on risk
Low risk tolerance
Medium risk tolerance
High risk tolerance
For illustrative purposes only. Neither asset allocation nor diversification guarantee a profit or eliminate the risk of loss. As market conditions change, so may the risk/reward potential of these investment types.
Risk capacity: your ability to take on risk
Low risk capacity
Medium risk capacity
High risk capacity
You may find your risk tolerance and capacity aren’t the same—that’s likely OK. Choose a mix of investments that balances the two and puts you in a suitable position to achieve your retirement savings goal while still sleeping at night without worrying.
Let your risk profile help guide your investment decisions
Determine your risk profile early—and often—to help develop your investment style and strategy. While thinking about your risk tolerance, keep in mind that you probably shouldn’t worry about your retirement investments’ performance daily, since they’re invested for the long term. And don’t let your risk tolerance influence your capacity for risk. Consider sticking to the numbers and mathematically determine how much risk you can afford. The two measurements balance each other, helping create an equilibrium to develop your investment strategy. Consider changing your investment strategy as life happens and your risk profile changes.
Consider consulting with a financial professional to help determine your risk profile and how to invest your money accordingly.
For complete information about a particular investment option, please read the fund prospectus. You should carefully consider the objectives, risks, charges and expenses before investing. The prospectus contains this and other important information about the investment option and investment company. Please read the prospectus carefully before you invest or send money. Prospectus may only be available in English.
The categorization of investment type as conservative, moderate, and aggressive is simply an example for consideration. This material is not intended to replace the advice of a qualified financial professional. Before making any financial commitment regarding the issues discussed here, consider consulting with the appropriate financial professional to determine risk tolerances and the suitability of various investments and asset allocations in view of your individual financial, investment, tax, family, and other personal considerations.
It is your responsibility to select and monitor your investment options to meet your retirement objectives. You should review your investment strategy at least annually. You may also want to consult your own independent investment or tax advisor or legal counsel.
John Hancock Retirement Plan Services LLC offers administrative and/or recordkeeping services to sponsors and administrators of retirement plans. John Hancock Trust Company LLC provides trust and custodial services to such plans. Group annuity contracts and recordkeeping agreements are issued by John Hancock Life Insurance Company (U.S.A.), Boston, MA (not licensed in NY), and John Hancock Life Insurance Company of New York, Valhalla, NY. Product features and availability may differ by state. Securities are offered through John Hancock Distributors LLC, member FINRA, SIPC.
John Hancock Investment Management Distributors LLC is the principal underwriter and wholesale distribution broker-dealer for the John Hancock mutual funds, member FINRA, SIPC.