How can that be? Risk tolerance is the amount of risk that each person is comfortable taking with their investment choices. Just because yours is different from someone else’s doesn’t mean it’s wrong. Or does it?

To better understand the issue, it helps to recognize that there are actually two ways that risk – as measured by volatility in this case – impacts your investment portfolio. The asset classes in which you choose to invest together with the percentage in each (aka your asset allocation) comprise the level of risk in your overall investment portfolio. And that level of risk corresponds to an expected level of portfolio returns over time. Of course, no one can predict the future. But based on statistical analyses of tons of historical data, the longer the time frame, the better the expected returns in aggregate will correlate with the actual returns.

However, everybody has their own unique lifestyle to maintain, each involving different levels of spending in all kinds of categories (home, education, family, community, travel, etc.). The amount of money you will need in order to support the spending above for your particular lifestyle over your remaining lifespan depends in part on your ongoing income, your savings, and the growth of your savings (that is, the lifetime returns on your portfolio). The latter can easily be estimated through a financial plan, and from that the corresponding level of risk expected to generate the needed level of returns can also be estimated. That risk level is sometimes referred to as your risk capacity.

When your investment selection process is based on your risk capacity, you are in effect putting together a portfolio with the necessary risk/return balance to meet your particular lifestyle. That’s a good way to invest. Unfortunately most people without a financial plan and/or CFP® professional to guide them will tend to make investment decisions based on their risk tolerance since it’s the most emotionally comfortable approach. If the two happen to match, there’s no problem. But if your risk tolerance is lower than your risk capacity you could be inclined to take less risk than required in order to get the needed returns from your portfolio over time. That could result in running out of money prematurely. And if your risk tolerance is the higher of the two, you could end up taking more risk than needed, potentially resulting in greater portfolio volatility and greater losses when withdrawals are taken during market downturns.

It’s also a fact that your risk tolerance changes based on environmental factors such as the prevailing economic situation. When things are going well investors’ risk tolerances tends to increase, and the reverse is true during recessions and market declines. To cite an example: in early 2009, during the depths of the so-called Great Recession, one of my clients had become so risk-averse that she was considering selling all her stock funds. Of course I spent time with her explaining the value of sticking to her investment strategy and ultimately helped her climb back down from the ledge. By 2010 – after her portfolio had rebounded not only from market growth but also from timely rebalancing – she had become so extremely risk-indifferent as to ask what could be done to get her portfolio to outperform that of her neighbor.

One of the key purposes of a financial plan is to identify your risk capacity and determine whether or not your risk tolerance is out of sync with your true risk capacity. Human beings make dysfunctional investment decisions when we rely on our emotions for decision-making. Having a plan and maintaining the discipline to follow it can help you avoid making suboptimal investment decisions that could cost you in later life.

(PERIGON is a registered investment adviser. More information about the firm can be found in its Form ADV Part 2, which is available upon request by calling 877-977-2555 or by emailing compliance@perigonwealth.com).