Risk tolerance.
In plain English
Risk tolerance is the level of decline in your portfolio's value you can experience without panic-selling. It is a behavioral concept, not a financial one: someone with a 30-year horizon and $2 million can have a low risk tolerance, and someone with a 5-year horizon and $50,000 can have a high one. Risk tolerance is what you actually feel when an account is down 30%, not what you say on a questionnaire when the account is up. The two often diverge.
01Why it matters
Portfolios designed for the risk tolerance someone claims rarely survive the risk tolerance they actually have. The cost of a mismatch is dramatic: an investor who panic-sells at a 30% drawdown locks in a loss that compounds into hundreds of thousands missed over a career. The most useful risk-tolerance test is honest reflection on the last drawdown someone lived through.
02The math, step by step
Two investors each hold $500,000 in a 90/10 stock-bond portfolio. The 2020 COVID crash takes both portfolios to $340,000 in five weeks. One holds through and ends 2020 above $500,000 again. The other sells at $340,000, re-enters at $480,000, and locks in a permanent loss of about $140,000 of would-be recovery.
03What this is NOT
Risk capacity is the amount of risk you can financially afford to take (based on time horizon, income, savings). Risk tolerance is the amount of risk you can emotionally handle. They are not the same number, and aligning the lower of the two with the portfolio matters more than maximizing either alone.