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Plan Well, Retire Well

Saving and investing your money

Friday, November 6, 2009

Risk Tolerance and Risk Capacity: What's Yours?

Posted by Karen Chan - Karen Chan Investing

Risk tolerance is a word that gets thrown around quite a bit when you read about investing. I think it's helpful to differentiate risk tolerance (your emotional reaction to risk) from your risk capacity (your financial ability to handle investment risk).

You're talking about risk tolerance when you ask questions like, "What would I do if the value of my investments dropped 30%?" You're trying to predict how you would respond. But you're assessing your risk capacity when look for facts about your financial situation, such as,

  • How many years will it be before I need to use this money?
  • How much do I save each year? Or, do I spend more than I earn?
  • How much do I have in my emergency fund? (Please note that your emergency fund should be saved, not invested. By that, I mean its value can't drop, or not by much.)
  • In retirement, how much of my expenses will be covered by Social Security or by a pension? And how much will I rely on my investments for my living expenses?

Determining how much risk you can handle and choosing an appropriate asset allocation may be as much art as it is a science. I'd be curious to hear what your personal experiences are, and what you think about the risk tolerance tools that are out there.

To learn about different types of investments and the various kinds of risk they have, visit University of Illinois Extension's interactive website, Plan Well, Retire Well, Your How-to-Guide at www.RetireWell.uiuc.edu. You can also read my latest news article about risk tolerance which is also posted on that webpage.



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