Understanding Your Risk Tolerance

Risk tolerance is one of the foundations of a sound investment plan. But understanding it is about more than asking how comfortable you are when markets fall.

A meaningful assessment combines two different questions: how much risk you can afford to take and how much risk you are willing to take. Both matter, and they should be considered before deciding how a portfolio should be invested.

Risk management starts with understanding the risks that can affect your financial life and determining how much uncertainty your financial situation can realistically absorb. Market volatility is part of that picture, but it is only one piece of it.

Before choosing an allocation, an investor should first understand their financial objectives, their time horizon and the risks that could prevent those objectives from being achieved.

Your financial situation changes, and so should your risk profile

The amount of risk an investor can reasonably take is not fixed throughout their life. Income, wealth, financial commitments and investment horizons all change over time.

It is useful to think about four broad stages:

1. Building the foundations. Early in a career, future earning power (or human capital) is often the investor’s largest asset, while financial wealth is still limited. The priorities are usually building an emergency reserve, managing debt and establishing a consistent savings habit.

2. Growing wealth. As income and financial assets increase, long-term objectives become clearer. Housing, family expenses, education and retirement may all compete for the same resources. With a longer investment horizon, there is generally more capacity to withstand temporary market declines.

3. Protecting accumulated wealth. Once significant wealth has been built, the objective gradually shifts from maximising accumulation towards preserving capital and maintaining financial flexibility. As important goals become closer, the capacity to absorb large losses usually decreases.

4. Using accumulated wealth. During retirement or another distribution phase, investments increasingly serve to fund spending. This makes sequence-of-returns risk particularly important: a significant market decline early in the withdrawal period can have a much greater impact than the same decline occurring decades earlier.

The result is simple: the same person may reasonably have a different risk profile at 30, 45 and 65. An allocation that makes sense during the accumulation phase may no longer be appropriate once the investor starts depending on the portfolio to fund their lifestyle.

Before looking at markets, look at your financial life

Market risk is highly visible because portfolio values move every day. But investors face several other risks that can be just as important and, sometimes, more consequential.

A complete assessment should consider:

• Income risk. The possibility of losing or reducing income through unemployment, illness, career changes or other disruptions. For many younger investors, future earning power is worth considerably more than their current investment portfolio.
• Longevity risk. The possibility of living longer than expected and running out of financial resources. Longer life expectancy makes it increasingly important for retirement savings to support a potentially longer period of withdrawals.
• Health and care risk. Medical expenses and the potential need for long-term care can create significant financial pressure, particularly later in life when there is less time to recover from a major loss.
• Housing risk. A large concentration of wealth in a single, relatively illiquid asset, often financed with debt, can reduce financial flexibility.
• Information risk. Making investment decisions without fully understanding the products involved, their costs, liquidity, risks or behaviour under adverse market conditions.

These risks directly influence how much portfolio risk an investor can reasonably accept.

Someone with unstable income, significant debt and no emergency reserve has less financial capacity to absorb a market decline than someone with stable income and substantial liquid savings, even if both investors describe themselves as equally comfortable with volatility.

How much risk can you take and how much can you live with?

Risk tolerance is often treated as a single concept. In practice, it is better understood through two separate dimensions: capacity and willingness.

Risk capacity is financial. It describes how much loss an investor can withstand without compromising important financial objectives. It depends on factors such as wealth, income stability, liquidity, financial commitments, investment horizon and the size and importance of future goals.

If an objective is distant and represents only a small proportion of an investor’s available resources, there is generally greater capacity to accept market fluctuations. If an essential objective is large and approaching, capacity is much lower, regardless of how confident the investor feels about markets.

Risk willingness is behavioural. It describes how comfortable an investor is with uncertainty and temporary losses. It can be influenced by personality, financial knowledge and, importantly, previous experience with financial markets.

Willingness is also difficult to assess during calm markets. An investor may believe they can tolerate a 30% decline when markets are rising, but their real tolerance becomes clearer when that decline actually happens.

Three questions provide a useful starting point:

1. What are your short- and long-term financial goals?
2. How important is each goal, and what would happen if you could not meet it on time?
3. How large a portfolio loss could you withstand without putting your most important goals at risk?

The answers need to be considered together.

When financial capacity and psychological willingness point in different directions, the more conservative constraint should normally prevail.

An investor with high capacity but low willingness may be financially able to tolerate a large decline but still sell during a downturn because the experience becomes psychologically unbearable. That decision can turn a temporary market loss into a permanent one.

The opposite situation can be equally problematic. An investor may be highly willing to take risk, but if their financial capacity is low, an aggressive portfolio could expose essential goals to losses they cannot afford to recover from.

The longer the horizon, the more room there is for uncertainty

Monthly-rebalanced portfolio of 50% MSCI World (net, EUR) and 50% Bloomberg Global Aggregate (EUR hedged), 2007-01-01 to 2022-01-26. Source: PortfolYou, based on index data. Past performance does not predict future results.

The history of a balanced portfolio illustrates an important point: investing requires accepting periods of uncertainty and decline.

During the period shown, the portfolio grew from 100 € to approximately 232.1 €, while experiencing a maximum drawdown of 27.8% along the way. Every label on the chart was, at the time, a reason to sell.

Those drawdowns are not merely numbers on a chart. At the time, each one represented a situation in which an investor could reasonably have questioned whether they should continue holding the portfolio.

The important question is therefore not whether a similar decline will happen again. It is whether your financial situation and your behaviour would allow you to remain invested if it did.

Time horizon is one of the most important factors determining risk capacity. Over short periods, equity returns can vary considerably and significant losses can occur. Over longer periods, investors have more time for markets to recover from temporary declines, although a longer horizon does not eliminate investment risk or guarantee positive returns.

This is why the same investment can be appropriate for one investor and inappropriate for another. Risk does not exist independently of the investor: it depends on the relationship between an investment’s behaviour, the investor’s objectives and the time available to achieve them.

We explore the historical evidence behind long-term equity investing, including major market drawdowns, in The Enduring Case for Stocks.

Turn your risk profile into an investment decision

Understanding your risk tolerance is useful only if it leads to better decisions.

That is precisely what the Investor Profile tool does: a structured questionnaire that works through your goals, your time horizon, your capacity and willingness to take risk, and turns the answers into a profile. That profile is the foundation on which an Investment Policy Statement and the allocation decisions that follow are built.

Your tolerance will also change: with a new job, a family, an inheritance, retirement on the horizon. The right moment to re-measure it is when life changes, not when markets do.

Adapted from “Qual o seu nível de tolerância ao risco financeiro?”, originally published on the Future Proof blog.