What's Your Risk Capacity?
When establishing your portfolio's asset mix, it's important to consider your risk tolerance, or the degree to which you can emotionally endure losses. But there's another side to the coin: risk capacity.
Risk tolerance vs. risk capacity
Risk tolerance is a state of mind and can fluctuate wildly in response to the market. Risk capacity, on the other hand, is fixed: Your goals have an end date, and you either have time to bounce back from losses or you don't.
When your risk capacity and risk tolerance don't align, it creates challenges—especially as your time frame shrinks. Let's look at two such scenarios:
- When the market is struggling and portfolio values are dropping quickly, investors with a low risk capacity might be tempted to cut back on their stock exposure or cash out entirely in an attempt to soften the blow. But selling in a downturn just means locking in those losses and potentially missing out on the rebound, making it that much harder to recover your lost funds (see "Staying the course").
- When the market is on fire, on the other hand, investors tend to take on more risk than is prudent. Feeling like you're missing out on gains can lead you to increase your exposure to higher-risk, higher-reward investments. But if you're nearing your goal, you should focus on preserving what you've saved rather than risking it for the prospect of a few extra percentage points.
Staying the course
Cashing out during every downturn may curtail some losses—but it's also likely to undercut gains as the market recovers. And the longer you sit on the sidelines, the farther behind you'll fall.
Source: Schwab Center for Financial Research with data from Morningstar, Inc.
The market is represented by the S&P 500® Total Return Index, using data from January 1970 to October 2024. Cash is represented by the total returns of the Ibbotson U.S. 30-Day Treasury Bill Index. Total return includes reinvestment of dividends, interest, and other cash flows. Since 1970, there have been seven periods where the market dropped by 20% or more. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes, please see schwab.com/indexdefinitions. Past performance is no guarantee of future results. This hypothetical example is only for illustrative purposes.
Risk capacity and your portfolio
Your risk capacity, not your risk tolerance, should drive your investment decisions for your near –term goals. But determining whether your portfolio aligns with your goals isn't always straightforward. For example, you may have a retirement date in mind, but that doesn't mean you need access to all your savings on that date.
Generally speaking, you should have two to four years' worth of expenses in stable, relatively liquid investments, but the rest of your portfolio can be invested for long-term growth. In that way, your overall capacity for risk might actually be higher than you assume.
When in doubt, an advisor can help ensure the risk in your portfolio aligns with your capacity to weather a downturn.