Too Much Risk? The 6 Components of Behavioral Loss Tolerance

My favorite BLT is a sandwich. My second favorite is behavioral loss tolerance.

We’ve discussed before that each of us has a “willingness, ability, and need” to take on risk.

More specifically, your need and ability for risk are objective and numerical.

Your need to take risk relates to the amount of objective investment growth required to meet your financial goals.

Your ability to take risk is based on your capacity to withstand or recover from losses (either temporary or permanent). Whereas need is a function of required growth, ability is a function of recovery from loss.

But your willingness to take on risk is subjective and a matter of feelings and psychology. It’s purely mental. How will you react to the higher volatility that comes with high-risk investments? Are you willing to stomach losses?

Today, I want to dive deeper into your willingness to take risks, or the more technical term for it: “behavioral loss tolerance.” Specifically, I’ll focus on the six agreed-upon components of an investor’s behavioral loss tolerance. Let’s dive in.

Risk Tolerance

Risk tolerance describes your readiness to engage in financial behavior with uncertain outcomes and potential for loss.

It typically measures how much loss someone is comfortable facing before feeling the need to exit their investment and/or reduce their exposure to losses.

Risk tolerance is often assessed via a questionnaire. Some typical risk questionnaire questions include:

• How many years do you plan to keep your money invested before needing it?
• How do you feel about short-term losses in exchange for long-term growth?
• If your portfolio dropped 20% in a year, what would you do?
  • A. Sell everything
  • B. Sell some to reduce risk
  • C. Hold steady
  • D. Buy more while it’s down
• Would you rather:
  • Gain 4% per year with little volatility
  • Have a 50/50 chance of gaining 12% or losing 5%
• How often do you check your investment account balances?
• If your $100,000 portfolio dropped to $85,000 in 6 months, what would you most likely do?
• Imagine two investments – which would you choose?
  • Investment A: Expected return 6%, worst year -10%
  • Investment B: Expected return 10%, worst year -30%

Risk Preference

Risk preference represents your general desire to take more or less risk. This is where you might describe your personal attitudes and priorities about risk.

Would you rather preserve your money, even if it means lower growth? Or do you value compounding your money, even if it means occasional losses? What’s your first instinct when you think about investing: seeking growth or preventing loss?

How do you describe yourself as an investor, on a spectrum from ultra-conservative to ultra-aggressive?

Would you rather own…

• A slow-and-steady bond fund with minimal risk
• A diversified portfolio of stocks and bonds
• A high-growth stock fund that might be volatile

These answers shed light on your risk preference.

Financial Knowledge

Financial knowledge represents your financial education and training.

I love financial knowledge. “An investment in knowledge pays the best interest,” right?! A strong foundation of financial knowledge helps interpret and emotionally process what’s happening in your personal finances and portfolio.

I would wager that people with stronger financial knowledge tend to:

• Better understand that short-term losses are normal
• Know the historical returns (and risks) of different asset classes
• Have more realistic expectations for returns
• Feel more in control of their investment decisions
• Avoid panicking when markets drop

In contrast, someone with low financial knowledge might:

• Think a (-10%) market drop is unusual or catastrophic
• Confuse short-term volatility with long-term failure
• Believe they always need to “do something” during downturns
• Overestimate the safety of cash or fixed income

Financial knowledge doesn’t guarantee high behaviroal loss tolerance. But it can raise someone’s ceiling by helping them stay rational and grounded when markets test their nerves.

Investing Experience

Investing experience describes your time and experiences in the world of investing. Specifically, someone can have substantial financial knowledge and limited financial experience, or vice versa.

Investing experience reflects how much real-world exposure someone has had to the ups and downs of markets through actually putting money at risk. It’s the lived version of financial knowledge.

During one of my first flights, I remember some (relatively minor) turbulence scared the heck out of me. I had no experience, nothing to judge against.

Only in time did I realize 1) turbulence is normal and 2) what I experienced was just a drop in the bucket.

There’s a similarity in investing.

Experience brings emotional muscle memory. Someone who’s seen losses, held steady, and watched recovery has a deeper, calmer relationship with risk.

Contrast that with someone new to investing. Even if they’ve read all the right books, they haven’t felt the stomach drop of a bear market or the thrill of a bull market. Their risk tolerance is untested.

The questions here are straightforward:

• “How long have you been investing?”
• “What was your first market downturn, and how did you handle it?”
• “Have you ever made a decision with your investments that you later regretted?”
• “Do you remember what you did in 2008, 2020, or 2022?”

Investing experience is about scar tissue.

Risk Perception

Risk perception is a subjective assessment of the riskiness (or lack thereof) of investing. It’s typically influenced by your social interactions, by the media, and your understanding of financial concepts.

Two people can look at the same investment and see very different things.

• One sees a temporary dip as a buying opportunity.
• The other sees it as a sign to sell, and fast.

Their behavior isn’t always based on facts or stats, but on their perception of what’s happening and what might happen next.

Risk perception is often shaped by:

• Recent market events (Recency bias)
• Media narratives
• Personal or family history (“My parents lost everything in 2008…”)
• Cultural or generational mindsets (“Markets are a casino…”)

Some open-ended questions to consider include:

Ask open-ended questions like:

• “What does ‘risk’ mean to you?”
• “Do you see investing as a positive thing? A way to grow wealth? Or as something you need to be cautious about?”
• “What concerns do you have when markets go down?”

The goal is to uncover how you frame risk, not just how you react to it.

Risk Composure

Risk composure measures your actual behavior during difficult market conditions. It’s your ability to stay calm and stick with your investment plan when markets get choppy. It reflects your emotional steadiness in the moment, especially during volatility, uncertainty, or loss.

In fact, some financial experts recommend you intentionally stay conservative until you’ve lived through a market crash, as you can’t truly know your risk composure until you’ve lived it.

People with high risk composure tend to:

• Stay invested through bear markets
• Avoid panic selling or reactionary moves
• Understand that downturns are part of the process
• Seek counsel or reassurance instead of immediately taking action

Whereas people with low risk composure tend to:

• Sell quickly during drawdowns
• Frequently change strategies or reallocate
• Feel emotionally overwhelmed during market stress
• Need frequent hand-holding from their advisor

Some good questions to ask to gauge your risk composure include:

• “Have you ever sold investments out of fear or stress?”
• “When markets fall, how often do you check your accounts?”
• “Do you feel pressure to ‘do something’ when the market is down?”

How Much Risk Can You Handle?

The hard part, in my opinion, is transitioning from all these excellent questions (and your answers) to an appropriate asset allocation for you.

There’s no perfect approach. But – your answers certainly help.

I think of it like a spectrum from white to black. I know most people are going to end up as gray. But there’s a world of difference between “gray, almost black,” and “gray, almost white.”

Similarly, as I wrote in “Pedal to the Metal,” I don’t see a massive difference between a 60/40 portfolio and, say, a 55/45 portfolio. And I’m not sure a risk questionnaire or your behavioral loss tolerance would help us draw a distinction there.

But there is a massive difference between, say, a 70/30 and a 50/50 portfolio. And while both are “shades of gray,” your behavioral loss tolerance can draw a distinction between those “shades.”

Behavioral loss tolerance, and its six sub-components, aren’t going to give you a “perfect answer,” so to speak.

But, directionally, they’re terrific. I’d recommend that any investor, new or old, understand where their answers lie.

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