The amount of investment risk you feel comfortable with (i.e. what you can sleep with at night) is called investment risk tolerance. However, market volatility often complicates the term. In good markets, your risk tolerance is higher, and in bad markets your risk tolerance sinks. Additionally, does it really make a difference if your portfolio dropped 15% or 20% in 2008? On a half million dollar portfolio, that’s a drop of $150,000 or $200,000. While $50,000 is certainly a lot of money, the fact is your investment portfolio dropped . . . and by a lot! Either way, you’re going to be frustrated with the paper losses. Because of this, we focus on two additional components.

Your investment risk capacity is the amount of investment loss you can withstand and still achieve your financial goals. For example, you may be perfectly comfortable with a 20% drop in a bad stock market; however, if you’re in the de-cumulation phase of life, your financial plan may be completely derailed! In this case, we must match your risk capacity with your financial plan to make sure you can withstand those inevitable market drops.

You may not be willing to tolerate a 20% drop in your investment portfolio, but that level of risk may be required to achieve your financial planning goals. For example, if your financial goals are so lofty your investments must produce an abnormally high rate of return, you must be willing to accept an investment portfolio with a commensurate level of risk. If you’re unwilling to accept a portfolio with that level of risk, you’ll need to either reduce your financial goals, or increase your investment savings.