When people talk about how much risk they can handle, they usually mean one thing. But there are actually two distinct questions, and confusing them leads to predictable problems.
The first question is psychological: how much volatility can you watch without panicking, selling, or losing sleep? This is risk tolerance.
The second question is financial: how much can you afford to lose without derailing your goals or your life? This is risk capacity.
These two things are not the same. They do not always move together. And when they diverge, the consequences can be serious.
This article explains what each concept means, why mismatches occur, how life circumstances change the answers, and what tends to happen when tolerance and capacity are out of alignment.
This is general educational information, not personal financial advice.
Defining Risk Tolerance#
Risk tolerance is psychological. It refers to the emotional and behavioural comfort someone has with uncertainty, volatility, and potential loss.
A person with high risk tolerance can watch their portfolio drop 30% and feel uncomfortable but not panic. They might even see it as an opportunity. A person with low risk tolerance feels genuine distress at much smaller movements. A 10% decline might keep them awake at night. A 20% decline might trigger an urge to sell everything.
Risk tolerance is influenced by personality, past experiences, and emotional disposition. Research suggests it is relatively stable over time, similar to a personality trait.¹ It does not swing dramatically from month to month. Someone who is naturally anxious about money at age 30 is likely to remain anxious at age 50, unless they do deliberate work to change their relationship with uncertainty.
That said, tolerance is not fixed forever. Major life events, such as experiencing a significant loss, going through a financial crisis, or watching someone close to you suffer financially, can shift tolerance in lasting ways. So can positive experiences: successfully riding out a market crash without selling can build confidence and increase tolerance for future volatility.
But the key point is that tolerance is about feelings. It answers the question: how does risk feel to me?
Defining Risk Capacity#
Risk capacity is financial. It refers to the objective ability to absorb losses without jeopardising important goals.
Capacity is determined by factors like:
- Time horizon. Someone investing for a goal 30 years away has more capacity than someone investing for a goal 5 years away. Time provides room for recovery.
- Income stability. A person with a secure, high-paying job has more capacity than someone with irregular freelance income. Stable income means less reliance on portfolio withdrawals.
- Existing wealth. A person with substantial assets has more capacity than someone just starting out. Losses represent a smaller proportion of total resources.
- Obligations. Someone with a mortgage, dependants, or other fixed costs has less capacity than someone with low expenses and no dependants. Obligations reduce flexibility.
- Liquidity needs. A person who might need to access the money within a few years has less capacity than someone who can leave it untouched for decades.
Capacity is not about feelings. It is about arithmetic. It answers the question: how much risk can my situation actually support?
Why the Distinction Matters#
Many investors conflate tolerance and capacity. They assume that feeling comfortable with risk means they can afford it, or that being financially secure means they should feel comfortable taking more risk.
Neither assumption is reliable.
Consider two examples:
High tolerance, low capacity. A young investor with limited savings, irregular income, and a mortgage feels bold about investing. They have watched markets go up for years and believe they can handle any downturn. But their financial situation cannot absorb a large loss. If their portfolio drops 40% and they lose their job at the same time (which often happens, since recessions affect both markets and employment), they may be forced to sell at the worst possible moment. Their tolerance told them they could handle it. Their capacity said otherwise.
Low tolerance, high capacity. A retiree with a large portfolio, no debt, and modest expenses feels anxious about every market movement. They hold mostly cash and conservative bonds. Their capacity is high: they could afford significant volatility because they have decades of runway and do not need the money soon. But their tolerance keeps them in low-return assets, which may not keep pace with inflation over time. They are financially capable of taking more risk but emotionally unwilling. The opportunity cost is real, even if it feels like safety.
Neither situation is wrong in a moral sense. But both involve a mismatch between tolerance and capacity, and both have consequences.
The Cost of Mismatch#
When tolerance and capacity diverge, something usually gives.
When tolerance exceeds capacity: The investor takes more risk than their situation supports. During a downturn, they may face forced selling (because they need the money), which locks in losses. Or they may experience financial stress that spills over into other areas of life. The emotional confidence that once felt like strength becomes a liability.
When capacity exceeds tolerance: The investor takes less risk than their situation could support. Over long periods, this often means lower returns, less wealth accumulation, and potential erosion from inflation. The money is "safe" in the short term but may not grow enough to meet long-term needs. This is a quieter cost, but it is still real.
Research shows that many investors experience some degree of mismatch.² The problem is that capacity is relatively easy to measure (it involves numbers and projections), while tolerance is harder to assess accurately (it involves introspection and often reveals itself only under stress).
People tend to overestimate their tolerance when markets are calm. It is easy to say "I could handle a 30% drop" when that drop is hypothetical. Living through it is different. The pain of actual loss is sharper than the pain of imagined loss. This is why tolerance questionnaires completed during bull markets often produce different answers than the same questionnaires completed during downturns.
How Life Circumstances Change the Answers#
Neither tolerance nor capacity is permanent. Both can shift as life circumstances change.
Changes That Affect Capacity#
Career transitions. A promotion with higher income increases capacity. Losing a job decreases it. Retiring eliminates earned income entirely, which fundamentally changes the capacity equation.
Family changes. Having children increases obligations and decreases capacity. Children leaving home decreases obligations and increases capacity. Divorce often reduces capacity for both parties.
Health changes. Serious illness can reduce income, increase expenses, and shorten time horizons. All of these reduce capacity. Good health and longevity can extend time horizons and increase capacity.
Housing decisions. Buying a house typically reduces liquidity and increases obligations, decreasing capacity. Paying off a mortgage increases capacity. Downsizing in retirement can significantly increase capacity by freeing up capital.
Windfalls and setbacks. Receiving an inheritance, selling a business, or any other large inflow increases capacity. Unexpected expenses, lawsuits, or financial losses decrease it.
Changes That Affect Tolerance#
Market experience. Living through a crash and successfully staying invested tends to increase tolerance. Suffering large losses (especially if combined with poor timing decisions) tends to decrease it.
Financial education. Understanding how markets work, why volatility occurs, and the historical pattern of recoveries can increase tolerance by reducing fear of the unknown.
Life stress. During periods of high stress (job uncertainty, relationship problems, health issues), tolerance often decreases. Emotional bandwidth is limited. When other areas of life feel uncertain, financial uncertainty becomes harder to bear.
Aging. Some research suggests tolerance decreases slightly with age, though this effect is modest and varies widely by individual.³ What often changes more is capacity, which then creates pressure to reduce tolerance accordingly.
When to Reassess#
Because both tolerance and capacity can change, periodic reassessment is important.
There is no universal frequency, but common triggers include:
- Any major life event (job change, family change, health change, housing change)
- Reaching a new life stage (starting a career, mid-career, approaching retirement, early retirement, late retirement)
- Experiencing a significant market event (major crash, prolonged downturn, unexpected rally)
- Noticing a change in how you feel about your portfolio (more anxious than before, or more detached)
Reassessment does not necessarily mean changing anything. It means checking whether the current approach still fits both the psychological and financial reality.
Aligning Tolerance and Capacity#
When tolerance and capacity are misaligned, the question is which one to adjust.
Adjusting capacity is sometimes possible. Building a larger emergency buffer, paying down debt, diversifying income sources, or extending the time horizon can all increase capacity. Reducing capacity is less common as a deliberate choice, but it happens naturally when obligations increase.
Adjusting tolerance is harder but not impossible. Education, gradual exposure to volatility, and working with a trusted adviser can all help increase tolerance over time. Decreasing tolerance is usually not a goal, but it happens naturally after bad experiences.
Adjusting the portfolio is often the most practical path. If tolerance is lower than capacity, a more conservative portfolio may be appropriate, even if it means leaving some potential returns on the table. Peace of mind has value. If tolerance is higher than capacity, a more conservative portfolio may be necessary to avoid catastrophic outcomes, even if it feels frustrating.
The general principle is to take the lower of the two as the binding constraint. If capacity says you can handle high volatility but tolerance says you cannot, the portfolio should reflect the tolerance. If tolerance says you are comfortable with high volatility but capacity says you cannot afford it, the portfolio should reflect the capacity.
This is not about being conservative for its own sake. It is about avoiding situations where you are forced to act against your own interests.
The Role of Self-Awareness#
The hardest part of this framework is honest self-assessment.
Capacity is easier because it involves numbers. Income, expenses, assets, debts, time horizons: these can all be measured.
Tolerance is harder because it involves predicting your own behaviour under stress. Most people are overly optimistic about this. They believe they will stay calm during a crash because they have read about the importance of staying calm. But reading about staying calm is not the same as staying calm.
One useful approach is to remember past behaviour. How did you actually respond the last time markets fell significantly? Did you check your portfolio obsessively? Did you feel an urge to sell? Did you stop contributing? Did you lose sleep?
If you have never experienced a significant downturn, you do not yet know your tolerance. You have beliefs about it, but those beliefs are untested.
This is not a character flaw. It is simply a limitation of self-knowledge. Acknowledging it is more useful than assuming you know the answer.
Summary#
Risk tolerance is psychological: how much volatility you can watch without panicking or making poor decisions. Risk capacity is financial: how much you can afford to lose without derailing your goals. These two concepts are often confused, but they are distinct. High tolerance with low capacity leads to taking risks you cannot afford. Low tolerance with high capacity leads to missing opportunities you could have taken. Both tolerance and capacity change with life circumstances, including career, family, health, housing, and market experience. Periodic reassessment helps ensure alignment. When tolerance and capacity diverge, the portfolio should generally reflect the lower of the two. The hardest part is honest self-assessment, especially about tolerance, which often reveals itself only under stress.
Sources#
- Roszkowski, M. J., & Davey, G. (2010). Risk perception and risk tolerance changes attributable to the 2008 economic crisis: A subtle but critical difference. Journal of Financial Service Professionals, 64(4), 42-53.
- Grable, J. E. (2016). Financial Risk Tolerance: A Psychometric Review. CFA Institute Research Foundation. https://rpc.cfainstitute.org/research/foundation/2018/risk-tolerance-and-circumstances
- Yao, R., Sharpe, D. L., & Wang, F. (2011). Decomposing the age effect on risk tolerance. The Journal of Socio-Economics, 40(6), 879-887. https://doi.org/10.1016/j.socec.2011.08.023