Who Am I?
Who am I? That’s a very good question. Have you ever thought about what type of investor you are? Determining your investor identity is like discovering your personal yin and yang. To be in harmony with your investment decisions, you must learn to balance risk and return.
As an investor, you have two aspects that determine your investor profile: your risk capacity and your risk tolerance.
- Your risk capacity quantifies your capacity to afford a loss; it assesses your ability to take on risk and absorb a loss in value of your investment.
- Your risk tolerance measures your emotional reaction to a loss; it is your willingness to lose some or all of your investment in exchange for higher returns. Other factors that affect your risk tolerance are your knowledge and experience in investing. People who have investment knowledge and experience in the markets are often better able to gauge and manage risk. The main question here is: how comfortable are you owning investments that might fluctuate with the markets?
Your capacity and tolerance for risk aren’t always the same. They can be affected by:
- Your investment objectives; and,
- Your time horizon: how long you invest until you need the money.
Discover Your Risk Tolerance
To get a better idea of your risk tolerance, take the test below. Click the button below to begin.
Defining your risk tolerance will help you identify which financial products you are most comfortable owning in your investment portfolio.
IFIC: Getting Started
Your Risk Capacity
“How much risk should I take? Is this the right investment for me?” There is a reason a financial planner’s favourite expression is, “It depends.” Risk capacity is a good example of why planners can’t give the same answer to everyone—because it’s very personal.
What does it depend on? Well, a number of things, including:
- How long will it be until you need the money? This question addresses your time horizon.
- Do you need ongoing, quick access to the money (such as if you had an emergency)? If yes, you need liquidity.
- Do you have considerable wealth, few assets or fit somewhere in between?
- Do you have unspent income or are you short of money every month?
- When time horizons are short, risk capacity is low because you can’t outwait a price drop before selling.
- As time horizons lengthen, risk capacity increases; a short-term drop in price doesn’t matter if you don’t need to sell.
- As liquidity needs rise, risk must be reduced or eliminated.
- The more assets you have, the greater your risk capacity; a small loss won’t matter as much.
- When income regularly exceeds expenses, your capacity for risk is higher due to:
- A greater capacity to save;
- Money coming in regardless of market conditions; and,
- A lower probability of selling when prices have dropped.
There’s more. Your risk capacity also depends on:
- The purpose (goal) for the money.
- Whether you can access it (for instance, money in a pension plan may be inaccessible).
Examples of Risk Capacity
Ruby is 28, with $50,000 in student loans, $15,000 in an RRSP and $25,000 in her company pension plan. She’s worried about losing her job and not being able to pay her bills. What’s her risk capacity? What investments should she choose in her RRSP and pension?
- RRSP: If she gets desperate for money, she could make a withdrawal. Her risk capacity is considered medium-low; low-risk investments are prudent.
- Pension: Pension regulations lock in the money. Unless she’s eligible to make a withdrawal under financial hardship rules, the money isn’t available. With a long time horizon to retirement, her risk capacity is high.
Luis is 55, with $350,000 in retirement savings, a modest house that is paid off and a spouse who is already retired. He wants to retire in 10 years with $1 million in his account. He’s ready and willing to take on very high risk for the next 10 years.
What’s the problem?
- Unless he wins a lottery, his dream of $1 million is not realistic. He needs to revisit his plan.
- Attempting to get high returns means choosing high risk investments, which are subject to big price swings.
- He doesn’t have the capacity for high risk. Every year he’ll be one year closer to retirement.
- If a big price drop occurs, he’ll have less time to make up the loss; his other assets are not huge.
Luis could start out with a medium-high risk portfolio but needs to transition to moderate risk by the time he retires.
Risk capacity answers the question, “How much risk do I have the capacity to handle?” See Beware: Risk Is Everywhere to learn more.