Risk Capacity vs Risk Tolerance

There are two aspects linked with an investor’s risk tolerance actual financial capability (risk capacity) to bear unforeseen losses and emotional capability (risk tolerance) to live with the loss. If an investor is unable to emotionally bear the loss under an unforeseen circumstance, he may be tempted to exit the market with his loss in hand without thinking further, although he had the financial capacity to bear the notional loss. For such a category of investors, market volatility is unacceptable and emotionally forbidden. They move out of the market at the wrong time and swear never to return. That is a folly driven either by fear or greed. For example, had an investor made a bet on stocks a year before the lockdown started, out of fear, he would have sold all his equities in March 2020 when the market was losing its ground on pandemic fear. On the other side. an investor with a reasonable risk tolerance would have wagered to put in more money as the market was falling in late March without fear and greed. That investor would have been sitting on a fabulous return by the time market recovered in the subsequent months. An investor who takes prudent decisions is never unhappy.