Understanding Your Risk Tolerance
The key to building a portfolio you can stick with.
Of all the factors that determine your long-term investment success, one of the most important is your ability to stay invested. And the key to staying invested is building a portfolio that aligns with your personal tolerance for risk.
Understanding your risk tolerance is about more than just filling out a questionnaire. It's a nuanced exploration of your financial situation, your emotional temperament, and your subjective view of the markets.
Risk Tolerance: Your Willingness to Take Risk
Risk tolerance is a measure of your emotional and psychological comfort with the ups and downs of the market. It answers the question: "How much of a portfolio decline can I stomach before I feel the urge to panic and sell?"
This is largely a function of your personality and temperament. Are you a natural worrier, or do you have a steady hand? Have you invested through a market crash before? Your answers to these questions help determine your willingness to take on risk.
Someone with a high risk tolerance might be comfortable with a portfolio that could drop 30% in a bad year, in exchange for higher potential long-term returns. Someone with a low risk tolerance might prefer a portfolio that is unlikely to lose more than 5-10%, even if it means lower growth.
Risk Capacity: Your Ability to Take Risk
Risk capacity is a purely financial measure. It answers the question: "How much risk can I afford to take without jeopardizing my essential financial goals?"
Time Horizon
If you don't need the money for 20+ years, you have a high capacity to take on risk because you have plenty of time to recover from any market downturns.
Financial Stability
If you have a secure income, a large emergency fund, and no high-interest debt, your capacity for risk is higher than someone with an unstable income and significant financial obligations.
Dependence on the Portfolio
If you are retired and living off your investments, your capacity for risk is much lower than someone in their 30s who is still in their peak earning years.
Risk Perception: Your Subjective View of Risk
Risk perception is your personal, subjective view of how risky a particular investment is. This is often shaped by media headlines, recent market performance, and personal biases.
For example, after a long bull market, investors' perception of risk tends to be low - they may feel that stocks are not very risky because they have only gone up recently. Conversely, after a market crash, risk perception is extremely high, and even sound long-term investments can feel terrifying.
A key role of a financial advisor is to help clients separate their subjective risk perception from the objective, long-term risk and return characteristics of different asset classes.
Finding the Right Balance
The ideal portfolio lies at the intersection of your risk tolerance and your risk capacity. Your portfolio should be aggressive enough to meet your long-term goals (satisfying your risk capacity) but conservative enough that you can sleep at night (respecting your risk tolerance).
If your tolerance is higher than your capacity (e.g., you love risk but are retiring next year), capacity must win. You cannot afford to gamble with funds you will soon depend on.
If your capacity is higher than your tolerance (e.g., you are young but terrified of any losses), tolerance should win. There is no point in building a theoretically "optimal" portfolio if you are going to panic and sell it at the first sign of trouble.
The SG Wealth Process
At SG Wealth, we use a combination of in-depth conversations and sophisticated risk profiling tools to gain a deep understanding of your unique risk profile. We don't just ask you to circle a number on a scale. We walk you through historical market scenarios to see how you would feel, and we stress-test your financial plan to understand how much risk you need to take to achieve your goals.
The result is a portfolio that is not just financially sound, but behaviourally sound - a portfolio you can stick with for the long term. This understanding is then captured in your personalized Investment Policy Statement (IPS).
Explore our comprehensive investment planning in Canada services to get started.
Discover Your True Risk Profile
Understanding your risk tolerance is the first step to building a portfolio you can confidently stick with through any market environment.
Book a free consultation and let our advisors help you find the right balance for your unique situation.