Understanding risk appetite, risk capacity and risk tolerance is very important before making any investments or any investment decisions.
Risk Appetite –
Risk appetite can be defined as the amount and type of risk that an investor is willing to take in order to meet its financial goals. Investors will have different risk appetites depending on various factors. A range of appetites exist for different risks and these may change over time.
While risk appetite will always mean different things to different people, a properly communicated, appropriate risk appetite statement can actively help investors achieve goals and support sustainability.
Risk Capacity –
Risk capacity is the amount of risk that the investor can 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.
Risk capacity is an objective measurement of the amount of risk you need to take in order to meet your established financial goals. It can also be used to assess the impact of any risk occurrence on your portfolio’s ability to meet your financial obligations.
Risk Tolerance –
Risk tolerance is a subjective measurement of your attitude toward risk, your willingness to accept potential investment loss in search of greater investment gain. 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 designed to reveal the level at which an investor can invest, but still be able to sleep at night. Those with a higher risk tolerance are more comfortable with market volatility and uncertainty than those with a lower risk tolerance.