How Much Investment Risk Can You Really Live With?

Over the years, I've had many conversations with families about investment risk.

One of the things I've learned is that two people with nearly identical financial circumstances can feel very differently about investing.

One person may be comfortable watching their investments fluctuate significantly, knowing they're investing for the long term.

Another may have the same amount of money, similar financial goals, and plenty of resources to support their lifestyle, yet become very uncomfortable when the market declines.

Neither reaction is necessarily right or wrong.

But understanding those differences is an important part of financial planning.

That brings me to the eighth question in our series:

How much investment risk can you really live with?

I think the answer requires us to consider two very different things: how much risk you can financially afford to take and how much risk you're emotionally comfortable taking.

The Difference Between Risk Tolerance and Risk Capacity

When we talk about investment risk, we often focus on risk tolerance.

In simple terms, risk tolerance is how comfortable you are with the possibility of your investments declining in value.

Some investors can watch the market fall 20% or more and remain relatively calm.

Others may become concerned after a much smaller decline.

But there's another important consideration: risk capacity.

Risk capacity is how much investment risk your financial circumstances allow you to take without jeopardizing your financial goals.

For example, someone with substantial investments, limited spending needs, and many years before they expect to use their money may have a relatively high capacity for risk.

But that doesn't necessarily mean they're comfortable taking it.

On the other hand, someone may enjoy investing aggressively and feel confident about market fluctuations, even though their financial circumstances suggest they should be taking less risk.

Just because you're comfortable taking a risk doesn't mean you can afford it. And just because you can afford a risk doesn't mean you need to take it.

A thoughtful financial plan should consider both.

How You Feel During a Market Decline Matters

It's easy to say you're comfortable with market volatility when markets are performing well.

The real test comes when they're not.

Think back to a time when the stock market experienced a significant decline.

How did you feel?

Were you comfortable staying invested?

Did you find yourself checking your account balances more frequently?

Were you tempted to sell investments and move to cash?

Did the headlines make you question your long-term strategy?

These reactions can tell us something important about our relationship with investment risk.

I've seen investors who believed they were comfortable with an aggressive portfolio discover during a market decline that they weren't nearly as comfortable as they thought.

And that's okay.

The purpose of understanding your risk tolerance isn't to judge your reaction.

It's to help design an investment strategy you can realistically maintain through both good markets and difficult ones.

Because even a well-designed investment strategy can become ineffective if an investor abandons it at the wrong time.

The Risk of Taking Too Much Risk

When investors take more risk than they're comfortable with, market declines can lead to emotional decisions.

They may sell investments after prices have already fallen.

Move into cash because it feels safer.

Or wait for the news to improve before investing again.

The problem is that markets don't announce when they've reached the bottom.

And by the time investors feel comfortable getting back in, a significant portion of the recovery may have already occurred.

This is one reason I believe investment decisions should be made within the context of a financial plan rather than in response to current market conditions.

A plan helps us understand why we're invested the way we are and what we should expect along the way.

There's Also a Risk in Being Too Conservative

We tend to think of investment risk as the possibility of losing money.

But there's another risk that doesn't always receive as much attention.

The risk of not earning enough to accomplish your long-term goals.

Someone who is extremely uncomfortable with market fluctuations may prefer to keep most of their money in cash or other conservative investments.

That may provide short-term comfort.

But over long periods, inflation can reduce purchasing power, and an overly conservative strategy may make it more difficult to support future spending needs.

For families planning for several decades, that can become a meaningful concern.

The objective isn't to eliminate investment risk entirely.

It's to understand which risks are worth taking to accomplish your goals and which risks may be unnecessary.

How Much Risk Do You Actually Need to Take?

This is a question I believe deserves more attention.

Investors often ask how much risk they can tolerate or how much return they should expect.

But I think there's another question worth considering:

How much risk do I actually need to take to accomplish what matters to me?

Suppose you've accumulated enough wealth to support your lifestyle, help your family, and accomplish your long-term goals.

Do you need to take significant investment risk simply because you can?

Maybe not.

On the other hand, if you have long-term goals that require your investments to grow over time, avoiding equities entirely may introduce a different set of risks.

The answer depends on your financial circumstances, time horizon, spending needs, and personal comfort level.

That's where comprehensive financial planning becomes valuable.

Rather than starting with an investment portfolio and hoping it works, we can start with what you're trying to accomplish and build an investment strategy around those goals.

Having a Plan Can Make Market Volatility Easier to Live With

One of the ways we approach investment planning at Heritage is by separating near-term financial needs from longer-term investment goals.

Money that may be needed in the next few years should generally be invested differently from money that won't be needed for 10, 15, or 20 years.

We believe in maintaining safer investments to help cover near-term cash needs while allowing long-term equity investments to remain invested through market fluctuations.

This approach doesn't eliminate investment risk.

But it can reduce the likelihood that a family will need to sell long-term investments during a market decline simply to meet current spending needs.

It also provides something I think is particularly valuable: perspective.

When markets become uncomfortable, we can return to the financial plan and ask whether anything has fundamentally changed.

If your goals, cash needs, and long-term circumstances remain the same, a temporary market decline may not require a change in strategy.

Sometimes the best decision is to stay focused on the plan you've already established.

Your Comfort With Risk Can Change Over Time

Just as your financial goals evolve, your relationship with investment risk may change too.

Someone who was comfortable with an aggressive investment strategy at age 40 may feel differently at age 65.

But age alone doesn't determine the appropriate level of risk.

Your financial resources, spending needs, other income sources, family responsibilities, and personal experiences all matter.

I've also seen families become more comfortable with investment risk after developing a comprehensive financial plan.

Once they understand how much money they need, where their income will come from, and how their investments support their goals, market fluctuations may feel less threatening.

That's another reason I believe financial planning should be an ongoing conversation.

Three Questions Worth Asking Yourself

As you think about your own investment strategy, consider these questions:

1. If my investments declined significantly tomorrow, would I feel comfortable staying with my current strategy?
2. Does my financial plan demonstrate that I can afford the level of investment risk I'm taking?
3. Am I taking more risk than I need—or avoiding risks that may be necessary to accomplish my long-term goals?

Your answers may reveal whether your current investment strategy is truly aligned with your financial plan.

The Goal Isn't to Take the Most Risk. It's to Take the Right Risk.

Over the years, I've come to believe that successful investing isn't about having the most aggressive portfolio or achieving the highest return in any particular year.

It's about having an investment strategy that gives you a reasonable opportunity to accomplish your goals—and the confidence to stay with it when markets become uncomfortable.

That requires understanding both your financial ability to take risk and your emotional willingness to accept it.

And those two things aren't always the same.

The best investment strategy isn't necessarily the one with the highest expected return. It's the one that supports your financial goals and that you can realistically stick with over time.

Coming Next: What Financial Decision Are You Most Proud Of?

In Part 9 of The Questions Investors Should Be Asking Themselves, we'll take a different approach and look at the financial decisions that have worked out well.

Whether it was beginning to save early, investing consistently, helping a family member, or making a meaningful life change, the decisions we're proudest of can reveal a great deal about our values and what we want our wealth to accomplish.

About This Series

The Questions Investors Should Be Asking Themselves is a 10-part series from Heritage Wealth Management exploring questions that can lead to more meaningful financial planning conversations.

Inspired in part by the perspectives of David Booth, founder of Dimensional Fund Advisors and author of Stay Calm, the series encourages investors to think beyond market performance and consider how their financial decisions support the people, goals, and experiences that matter most.

Because sometimes improving your financial life doesn't begin with finding a better answer.

It begins with asking a better question.

Disclosure: This material is for informational purposes only and should not be considered investment, tax, or legal advice. Investment strategies involve risk, including possible loss of principal. The questions and concepts discussed in this article were inspired in part by the work and perspectives of David Booth, founder of Dimensional Fund Advisors and author of Stay Calm. Heritage Wealth Management is not affiliated with or endorsed by David Booth or Dimensional Fund Advisors.