1.13. Time Horizon, Risk Tolerance, and Risk Capacity
Lesson objective
Relate investment time to personal circumstances.
The time horizon is the expected period before the money will be needed. A goal thirty years away can tolerate different fluctuations than an obligation due in twelve months.
Risk tolerance describes the emotional discomfort a person can withstand. Risk capacity depends on financial reality. Someone may feel comfortable with risk but still lack the capacity to absorb a loss if the money is needed soon.
Goals, income, debt, emergency savings, and job stability all influence this assessment. No single allocation is appropriate for everyone.
Three dimensions of risk suitability
| Dimension | Question | |---|---| | Time horizon | How long until the money may be needed? | | Risk tolerance | How much fluctuation can I emotionally accept? | | Risk capacity | How much loss can my finances actually absorb? |
Same personality, different capacity
Two investors may both say they can tolerate a 30% decline. One is investing for retirement 25 years away; the other needs the money for a home purchase in 12 months. Their capacity for risk is very different.
The investment should fit the goal, not the other way around. Define the date and acceptable downside before choosing the security.
What you should remember
- Time horizon, risk tolerance, and risk capacity are different concepts.
- Money needed soon generally requires greater liquidity and protection.
Practice
For each financial goal, record the date, amount, importance, and maximum loss you could tolerate.