Risk capacity is the financial ability to withstand potential losses without jeopardizing required goals or obligations. It differs from risk appetite: appetite describes willingness to take risk, while capacity describes what losses can be absorbed. section 7.3.2
Use capacity as a guardrail in risk management. An investor may welcome experimentation, yet still lack the financial room to expose essential goals to high-risk positions. section 7.3.2
Development versus production
Risk appetite resembles trying an untested change in a development environment. Risk capacity resembles deciding whether that change is safe for production: comfort with experimentation does not prove that failure is affordable. section 7.3.2
Treat limited capacity as a reason to scrutinize strategies that can magnify losses:
- Leverage can amplify gains and produce disastrous losses. section 7.3.2
- Short selling can create theoretically unlimited losses if prices rise. section 7.3.2
- Derivatives can magnify both gains and risks. section 7.3.2
