What Is Risk Tolerance?

Risk tolerance is a measure of how much loss you can withstand in your investments. Specifically, it refers to your psychological and financial ability to continue investing without panic-selling when your portfolio temporarily drops by a certain percentage.

For more detail, a practical book on portfolio design will give you a systematic understanding of how to combine asset classes.

If you start investing without properly understanding your risk tolerance, you will struggle to make rational decisions during market downturns. During the COVID-19 crash of 2020, global equities fell more than 30% in roughly one month. Whether you can endure watching a 10 million yen investment shrink to below 7 million yen depends entirely on whether you have assessed your risk tolerance in advance.

Five Factors That Influence Risk Tolerance

Risk tolerance is not one-size-fits-all - it varies greatly depending on individual circumstances. By evaluating the following five factors holistically, you can gauge your own risk tolerance.

  • Age: The younger you are, the higher your risk tolerance. A longer investment horizon gives you time to recover from temporary declines. A 100% equity allocation is rational in your 20s, but by your 60s, keeping equities at 30 to 50% is typical.
  • Income stability: Those with stable income - such as civil servants or employees of large corporations - have higher risk tolerance. Freelancers or commission-based workers face greater income volatility and should take less investment risk.
  • Total assets: The more financial assets you hold, the smaller the impact of a partial loss on your daily life. Losing 3 million yen (10%) on a 30 million yen portfolio has a very different psychological impact than losing 300,000 yen (10%) on a 3 million yen portfolio.
  • Investment experience: Those who have lived through a crash and witnessed the subsequent recovery can stay calm during downturns. Beginners tend to be more shaken than they expect, so starting with a conservative risk setting is wise.
  • Personality and psychological tendencies: People who are sensitive to fluctuations or prone to worry tend to have lower risk tolerance. If daily price movements distract you from work, it is a sign you are taking on too much risk.

Recommended Portfolios by Risk Tolerance

Here are three model asset allocations based on risk tolerance level. All assume a long-term investment horizon.

  • Conservative (low risk tolerance): Equities 30% / Bonds 50% / Cash 20%. Expected return of 2 to 3% per year with a maximum drawdown of roughly 10 to 15%. Prioritizes stability and avoids large swings.
  • Balanced (moderate risk tolerance): Equities 60% / Bonds 30% / Cash 10%. Expected return of 4 to 5% per year with a maximum drawdown of roughly 20 to 25%. Suitable for those who want a balance between risk and return.
  • Aggressive (high risk tolerance): Equities 90% / Bonds 10% / Cash 0%. Expected return of 6 to 7% per year with a maximum drawdown of roughly 30 to 40%. For those aiming to maximize long-term wealth who can tolerate short-term volatility.

For example, with a balanced portfolio of 10 million yen, the allocation would be 6 million yen in equities, 3 million yen in bonds, and 1 million yen in cash. In a crash on the scale of the Lehman Brothers crisis (equities −50%, bonds −5%), the portfolio would shrink to roughly 7.15 million yen. Whether you can endure an unrealized loss of 2.85 million yen is the litmus test for whether the balanced approach suits you.

Psychology During a Crash and How to Cope

When markets plunge, humans instinctively feel the urge to sell before losses grow further. Behavioral economics tells us that the psychological impact of a loss is roughly twice that of an equivalent gain - a phenomenon known as loss aversion bias.

  • Set rules in advance: Decide during calm times that "I will not sell even if the market drops 20%" or "I will continue my monthly contributions regardless of market conditions."
  • Take a break from checking: Tracking daily price movements makes you emotional. During a crash, deliberately avoid looking at your brokerage account for a period.
  • Review past crashes and recoveries: The Lehman shock (2008) saw a roughly 50% decline but recovered in about 5 years. The COVID-19 crash (2020) dropped roughly 30% but recovered in just six months.
  • Treat it as a rebalancing opportunity: A decline in equities is also a chance to buy at a discount. Build the habit of periodic rebalancing to restore your target asset allocation.

Risk tolerance is not fixed - it should be revisited as your age and life stage change. Use our simulator to compare outcomes at different return rates (risk levels) and find the optimal balance for you.

a practical guide to asset allocation will show you how to determine allocation ratios based on your risk tolerance.