Definitions
Risk Tolerance
Emotional ability to handle volatility and drawdowns.
Psychological factors:
- • How you react to losses
- • Sleep-at-night comfort level
- • Experience with volatility
- • Stress from market swings
Risk Capacity
Financial ability to take risk based on your situation.
Financial factors:
- • Time horizon to goal
- • Job stability & income
- • Emergency fund size
- • Debt levels
Quick framework
Decision Framework
- Time horizon: Longer = more capacity for equities
- 20+ years: 80-100% stocks possible
- 10-20 years: 60-80% stocks
- 5-10 years: 40-60% stocks
- <5 years: Focus on bonds/cash
- Cash buffer: 3–6 months emergency fund firstLarger emergency fund = higher risk capacity
- Debt situation: High-interest debt reduces capacityPay off >6% debt before investing in stocks
- Sleep test: If 30–40% drop keeps you up, lower equityTolerance limits trump capacity calculations
Risk tolerance assessment
Low Risk Tolerance
Suggested allocation: 20-40% stocks, 60-80% bonds
Moderate Risk Tolerance
Suggested allocation: 50-70% stocks, 30-50% bonds
High Risk Tolerance
Suggested allocation: 80-100% stocks, 0-20% bonds
Risk capacity factors
| Factor | Lower Capacity | Higher Capacity |
|---|---|---|
| Age/Timeline | <10 years to goal | 20+ years to goal |
| Job Security | Unstable, commission | Stable, tenure, pension |
| Emergency Fund | <3 months expenses | 6+ months expenses |
| Debt Level | High-interest debt | Low/no debt |
| Other Assets | Only retirement account | Multiple accounts, real estate |
| Dependents | Supporting family | Single, no dependents |
When tolerance and capacity conflict
Resolution Strategy
Rule: Use the lower of the two
If capacity says 80% stocks but tolerance says 40%, go with 40%.
Example scenarios:
- High capacity, low tolerance: Young person who panics during drops → Start conservative and increase exposure gradually
- Low capacity, high tolerance: Older person comfortable with risk → Stick to age-appropriate allocation despite comfort
How to improve over time
Building Risk Capacity
- • Build larger emergency fund
- • Pay down high-interest debt
- • Increase job skills/stability
- • Diversify income sources
- • Build non-investment assets
Building Risk Tolerance
- • Education about market history
- • Start with small amounts
- • Experience market cycles
- • Focus on long-term goals
- • Avoid checking daily prices
Frequently Asked Questions
What if tolerance and capacity conflict?
Use the lower of the two. It's better to invest conservatively and stay invested than to take too much risk and panic sell.
Can risk tolerance improve over time?
Yes—education and experience help. Start conservative and gradually increase stock allocation as you get comfortable.
Should I take a risk tolerance quiz?
Quizzes are a starting point but often oversimplified. Consider your real financial situation and how you actually react to losses.
How often should I reassess?
Annually or after major life changes (job change, marriage, kids, approaching retirement).