Discussions about risk generally revolve around two questions, and they are often used interchangeably. The first question is, How much risk can you handle psychologically? And the second one is, How much risk should you take on?

The answer to the first question is not always identical to the answer to the second, even though some financial advisors act like it is. Question one is about risk tolerance ; how comfortable we are watching our investment portfolios take a hit. But, just because a financial daredevil wants to take a risk, that doesn’t mean he or she should. That’s where Question two comes in. Unfortunately, risk tolerance alone is often used as the key factor when determining the asset allocation for a portfolio. This article will show how a blend of three factors that should be considered when creating a long-term investment strategy: risk tolerance, the financial capacity for risk and the optimal risk.

Risk Tolerance

Risk tolerance is a measure of your willingness to accept higher risk or volatility in exchange for higher potential returns. Those with high tolerance are aggressive investors, willing to accept losing their capital in search for higher returns. Those with a low tolerance, also called risk-averse. are more conservative investors who are more concerned with capital preservation. The distinction is justified only by the investor’s level of comfort.

A risk-tolerant investor will pursue higher potential reward investments even when there is a greater potential for a loss. A risk-tolerant individual might not sell his stocks in a temporary market correction, while a risk averse person might panic and sell at the wrong time. On the other end, a risk-tolerant person could be seek out high-risk investments, even if they add little to his or her portfolio.

Risk tolerance is a measure of how much risk you can handle, but that is not necessarily the same as the appropriate amount of risk you should take. That brings us to the second risk assessment that should be done.

Capacity to Accept Risk

When applying the concept of risk to investing, there are really two types of risk-related attributes that are quite distinct. One is a psychological attribute known as risk tolerance which we’ve already discussed. The other deals with financial ability or capacity to tolerate risk.

Example — Differences in capacity to tolerate risk.

Let’s consider the fate of three investors who each see a 50% drop in the value of their portfolios.

• C. Montgomery Burns. Mr. Burns is over 100 years old and has made billions as a captain of industry and atom smasher. His estimated net worth is $16.8 billion.
• Homer Simpson. Homer is in his late-30s and works as a safety inspector in Mr. Burns’ nuclear plant. He has a family to support and is slowly nearing retirement. We’ll be generous and give him a retirement portfolio of $100,000.
• Bart Simpson. At age 10, Bart is just beginning his investment career. He recently won a court settlement against the Krusty-O cereal company for $500, which is his current net worth.

A loss of 50% would drop Mr. Burns down to a paltry $8.4 billion. While Burns would no doubt be incensed at the loss, $8.4 billion is still enough to buy him all the ivory back-scratchers he could ever need. Bart, too, has the capacity to absorb a financial hit of 50%. He has many years to continue saving and investing before he needs to think about retirement.

Those with high income and high wealth can make higher-risk investments because they have funds coming in regardless of the market conditions. Similarly, young investors, with limited funds to invest, have the capacity for high risk, because they have longer time horizons. Any short-term drops can be waited out, lowering the chance of having to withdraw before the markets bounce back. This brings us to the third consideration, the optimal risk of the portfolio itself.