Risk Tolerance vs. Loss Tolerance
Submitted by Desmond Wealth Management, Inc. on October 16th, 2015Looking at your ability to take on risk is one thing, but the ability to accept loss is very different. Don’t get these confused. These two little words “risk” and “loss” are not interchangeable.
Risk is the potential for a loss.
Loss is the realization of that potential.
For example, risk is escaping from Alcatraz and swimming across the bay to freedom. Loss is drowning in the ocean on the way to shore or getting shot by the guard when you arrive.
Risk is walking blindfolded across a wire between two high-rise buildings. Loss is losing your step and plummeting to the sidewalk.
All risks do not result in losses, and all losses do not result from risks.
- Risk is putting a revolver with one bullet up to your head and pulling the trigger.
- Loss is getting hit with that one bullet.
- A risk without loss is when you pull the trigger and all you hear is ‘click’.
- Loss without risk is putting a revolver FULL of bullets up to your head and pulling the trigger.
Your Ability to Handle Risk
Risk is the assessment of the future potential losses, whereas loss is the result of what has already happened in the past. The ability to handle risk needs to be looked at in conjunction with the ability to handle loss. 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.
When looking at the ability to handle risk, several factors are relevant including the time horizon that you have to invest, future earning capacity, and the presence of other assets such as a home, pension, social security or inheritance.
The ability to handle risk is often dependent upon the level of stability already present in the overall resources available for funding goals. In general, one can take greater risk with investable assets when there are other, more stable sources of funds available.
Your Need for Risk
The amount of risk that ‘must’ be taken in order to reach financial goals is commonly known as Risk Capacity. The rate of return necessary to reach the goals can be estimated by examining time frames and income requirements. Then, rate of return information can be used to help decide the level of risk to take on. If the need for risk is greater than the risk tolerance or the loss tolerance, careful planning needs to be done to mitigate the potential losses.
Your Ability to Handle Loss
When reviewing the amount of risk to take in your portfolio, consider how your life would be affected if you lost 10%, 30%, 50% of your portfolio. Turn that percent into actual dollars. If losing a portion of your actual dollars will significantly affect your lifestyle and your future, perhaps your loss tolerance is lower than your risk tolerance.
Carefully consider your Risk Tolerance, your Risk Capacity and your Loss Tolerance when determining the proper allocation in your portfolio.