Being willing to take investment risk and being financially able to take investment risk are two different things. A good investment strategy needs to account for both.
When we talk about investment risk, we tend to focus on one question: How would you feel if your portfolio dropped 20%?
It's an important question, but it only tells us how much risk you're willing to take. It doesn't tell us how much risk you can actually afford to take. In financial planning, we call these two concepts risk tolerance and risk capacity, and the difference matters more than you might think.
Imagine two investors who each have $1 million invested and say they would be perfectly comfortable watching their accounts temporarily fall to $800,000. One is 45, still working and saving, and doesn't expect to touch the money for another 20 years. The other is 65, retiring next month, and will soon rely on the portfolio to help pay the bills.
Emotionally, they may feel exactly the same about risk. Financially, they're in two very different positions.
Risk Tolerance Is About You. Risk Capacity Is About Your Plan.
Risk tolerance is the emotional side of investing. How comfortable are you with uncertainty? How much of a decline could you watch before you started losing sleep, or felt tempted to make a change?
There's no right answer. Some investors can watch the market fall 20% and barely flinch. Others are uncomfortable with much smaller swings. FINRA makes an important distinction here: the amount of risk an investor can afford to take isn't necessarily the same as the amount they're comfortable taking.
Risk capacity, on the other hand, is about your financial situation. How soon will you need the money? Are you still earning and saving, or are you withdrawing from the portfolio? How much of your lifestyle depends on your investments? Do you have other reliable income or cash available?
Put more simply: If the market fell significantly tomorrow, would anything about your financial life have to change?
Our 45-year-old investor may not like seeing $1 million become $800,000, but they have time on their side. They're still earning a paycheck, continuing to save, and may not need the money for decades.
For the new retiree, that same decline could be more consequential. If the portfolio is also funding living expenses, they may need to sell investments while prices are down. That leaves fewer dollars invested to participate in a future recovery.
Same market decline. Same starting portfolio. Very different impact.
The Math of Losing Money
There's another reason losses deserve attention: recovering from a loss requires a larger percentage gain than the percentage you lost. If a $1 million portfolio loses 20%, it falls to $800,000. A 20% gain from there only gets it back to $960,000. It takes a 25% gain to return to $1 million.
- A 10% loss requires an 11.1% gain to recover
- A 20% loss requires a 25% gain to recover
- A 30% loss requires a 42.9% gain to recover
- A 40% loss requires a 66.7% gain to recover
- A 50% loss requires a 100% gain to recover
This isn't an argument for avoiding investment risk. Taking too little risk can create problems of its own, particularly when your money needs to keep pace with inflation and potentially support decades of future spending. The point is that the consequences of a market decline depend heavily on when you need the money and what else is happening in your financial life.
Sometimes the Problem Is the Opposite
Risk tolerance and risk capacity can also clash in the other direction.
Suppose your financial plan shows that you have plenty of capacity for investment risk. You have strong income, adequate cash reserves, and many years before you'll need the money, but after living through the dot-com crash, the 2008 financial crisis, COVID, and other uncomfortable markets, you simply don't want that much volatility.
That matters, too.
A portfolio can look perfect on paper and still be a poor fit if you're unlikely to stick with it when markets get uncomfortable. Vanguard studied investor behavior during the COVID-19 crash, when U.S. stocks fell about 34% in just over a month. Among the investors Vanguard studied who responded by moving entirely to cash, more than 80% would have been better off through May 2020 if they had simply stayed invested.
That doesn't mean staying invested will always lead to a better outcome. It illustrates a different problem: getting out of the market creates another decision about when to get back in. By the time investing feels comfortable again, markets may already have moved.
So while your financial plan helps determine how much risk you can take, your behavior helps determine how much risk you realistically should take.
Your Risk Questionnaire Doesn't Know Your Financial Plan
Most investors have probably completed some version of a risk questionnaire. It might ask what you would do if your investments fell 10%, how long you plan to invest, or whether you consider yourself conservative, moderate, or aggressive.
Those questionnaires can be useful. But they don't know that you want to retire in three years, buy a second home, help a child with a down payment, or start taking $8,000 a month from your portfolio. They also don't know whether a pension covers most of your expenses or whether your investments need to fund nearly everything.
That's why investment decisions shouldn't happen separately from financial planning.
Instead of asking only how much risk you are comfortable taking, there are three better questions worth working through:
- How much risk am I willing to take? That's risk tolerance.
- How much risk can I afford to take? That's risk capacity.
- How much risk do I actually need to take to reach my goals? That's where your financial plan comes in.
Sometimes all three answers line up. Sometimes they don't, and that's often where the most useful planning conversations begin.
You may discover that you don't need to take as much risk as you thought. You may find that being too conservative creates a different kind of risk. Or your investments may be perfectly reasonable, but you need more cash available so the next market decline doesn't interfere with your near-term plans.
The goal isn't to take the most risk possible, or the least. It's to take the right amount of risk for the life your money is supposed to support.
Sources
- Financial Industry Regulatory Authority (FINRA), Know Your Risk Tolerance, October 9, 2024.
- Financial Industry Regulatory Authority (FINRA), Report on Digital Investment Advice, March 2016.
- Thomas J. De Luca and Jean A. Young, Vanguard, Cash Panickers: Coronavirus Market Volatility, 2020.