The inherent definition of the word risk means undertaking an endeavour which has a chance of a negative outcome or the absence of a good outcome. Risk, in the financial field, is measured in many different ways, and it is an important concept for everyone to understand.
There are three different types of risks in this field. Risk tolerance, risk capacity, and risk appetite. In this blog, we will look at the first two types, as they are the most commonly discussed, and we will take a loot at what differentiates them.
One of the biggest mistakes made when it comes investor profile questionnaires is that they use the terms rather intechangeably when they shouldn’t. Using them interchangeably can bring a big impact on the strategy that you are using, and it won’t necessarily be a positive impact either.
So, let’s take a look at what these two types of risk bring to the table:
Risk Tolerance vs. Risk Capacity – A Comparison
Risk Tolerance
The first thing that you have to know about risk tolerance is that it is an inherently subjective concept. Risk tolerance has more to do with the mindset of the investor, their current emotional state and their current financial circumstances in relation to all that. Risk tolerance also factors in the investor’s personality.
Risk tolerance questionnaire will try to gauge the mentality of the investor. How much they can tolerate in the face of uncertain financial circumstances and how much of a chance of risk they can bear.
For example, one investor might pull their stocks out at the first sight of financial uncertainty, because they are inherently a person prone to panic or they don’t have the financial security to bear the kind of loss their current investment could bring to them.
Whereas, another person would be the opposite, and can bear the uncertainty, because they aren’t necessarily a panicky person or can adjust to any potential loss that their investment might bring.
Risk Capacity
In contrast with risk tolerance, risk capacity is a purely objective concept. Rather than measuring the mindset and the personality of the investor and measuring how vulnerable they are to making decisions in the face of financial security, a risk capacity questionnaire will measure the exact financial situation of the investor and how much they can afford to lose when it comes investments.
Billionaires such as Mark Zuckerberg, Jeff Bezos and the like can stand to have billions of dollard wiped off of their financial portfolios because they have risk capacities and assets that are designed to bear that kind of loss.
In contrast, a small business owner would not have anywhere near that kind of risk capacity because they just don’t have that kind of investment or because they don’t have the capital backing their investment to bear a huge loss. Therefore, the maximum amount of investment damage that a person can take is called risk capacity, and it is a decided, objective amount.
Risk tolerance and risk capacity, both have their place in the financial planning phase. And in some circumstance an analysis of rick tolerance is more useful, whereas other times a risk capacity analysis is more relevant.
It should also be mentioned that a person that has a high risk capacity might not have a high risk tolerance. And vice verse, a person with high risk tolerance might not have the capacity to risk those kind of finances.
In Conclusion
If you want to ensure that your financial advisory firm is providng your clients with the best investing adavice, then you can rely on our investor suitability questionnaire. It is one of the most advance questionnaires out there. Not only that, it is a whole system based on academic research that provides much more versatility then just a questionnaire form.
From personalisation to security, and compliance certifications, Pocket Risk has it all. Contact us today for more information.