Picture this: you’re comfortably seated on a flight when the captain’s voice crackles over the intercom:

"Just letting you know that we’re expecting some turbulence on this flight."

Hearing that announcement, you might feel a twinge of unease, but for the most part, you stay relaxed. You know turbulence is a common occurrence, so there’s no need to worry—yet.

But fast forward 30 minutes, and the plane suddenly drops several hundred feet. Drinks are spilling, overhead compartments rattle, and for a moment, your stomach feels like it’s in your throat. Suddenly, what felt manageable a few moments ago has turned into a white-knuckle experience.

This is exactly what happens when people assess their risk tolerance.

When asked hypothetically, most investors feel confident about taking on risk. They say they’re comfortable with the ups and downs of the market and are prepared to ride it out. However, when the market suddenly drops 20% and their portfolio loses thousands of dollars overnight, that theoretical risk tolerance evaporates. Panic sets in, and many rush to sell—locking in losses that could have been recovered if they’d stayed the course.

This gap between what we think we can handle and what we actually experience is crucial to recognize. Because, like the unexpected turbulence on a flight, it’s not the knowledge of potential market swings that matters—it’s how we feel and react when they happen in real life.

So, let’s take a closer look at why people tend to overestimate their risk tolerance and what you can do to create a plan that matches your real comfort level.

Defining Risk Tolerance: What Is It, Really?

Risk tolerance is the level of market volatility you can handle without losing sleep—and without making impulsive decisions. It’s a combination of two elements:

• Emotional Tolerance : This is how much anxiety or stress you feel when your portfolio takes a hit. It’s your gut reaction to market turbulence, and for many, it’s stronger than they expect.

 

• Financial Ability : This reflects your capacity to absorb losses without jeopardizing your long-term financial goals. It’s shaped by factors like your income, investment timeline, and overall financial situation.

Most risk tolerance assessments focus on these aspects through questionnaires and hypothetical scenarios. But, as we highlighted in the airplane analogy, knowing your tolerance in theory is very different from experiencing it in real time. People often overestimate their ability to stay calm when faced with actual losses.

For example, when markets are climbing steadily, it’s easy to say you’re comfortable with risk. But when your portfolio drops 20% in a matter of weeks, that confidence can quickly turn into a panicked urge to “do something” to stop the bleeding. This reaction can lead to costly decisions, such as selling low and locking in losses.

That’s why it’s crucial to assess both the emotional and financial sides of your risk tolerance before building an investment strategy. If you don’t, you might find yourself holding on to a portfolio that feels safe—until the turbulence hits. And that’s when theoretical risk tolerance collides with reality.

The Gap Between Perception and Reality: Why You’re More Conservative Than You Think

Most people believe they’re prepared for market swings—until they actually experience them. Behavioral biases play a big role in why many of us overestimate our true risk tolerance. Here’s a closer look at why this happens:

1. Loss Aversion Bias

Psychologically, the pain of losing money is far greater than the pleasure of making it. Research shows that losses are felt twice as strongly as gains of the same amount. So, while a hypothetical loss of 10% may seem manageable in conversation, the reality of watching your portfolio shrink in value can be emotionally overwhelming.

Example: Imagine telling yourself that a 15% dip is “no big deal” when the market is up. But when that same dip occurs, and your $500,000 nest egg is suddenly worth $425,000, it feels a lot more serious. The fear of further losses can lead to impulsive selling, locking in those losses rather than waiting for a rebound.

2. Recency Bias

People often give more weight to recent events, assuming that what just happened will continue to happen. When the market is soaring, you may feel more comfortable taking on additional risk. But when the market suddenly shifts and dips significantly, recency bias can turn your confidence into panic, making you feel as though the losses will never stop.

Example: After a few years of strong returns, investors tend to underestimate risk, forgetting the pain of previous downturns like the 2008 financial crisis. When the 2020 pandemic crash hit, many investors were caught off guard, despite knowing from past experience that downturns are a natural part of market cycles.

3. Herd Mentality

When markets get turbulent, and the media is filled with panic-inducing headlines, it’s natural to feel the urge to “follow the crowd” and sell off your investments like everyone else. This herd mentality can cause people to deviate from their long-term strategies, amplifying short-term fear over long-term planning.

Example: During the 2008 financial crisis, many investors sold at the bottom, fearing that things would only get worse. By the time the market recovered, they had already exited, missing out on significant gains.

These biases, along with the emotional toll of seeing your hard-earned money shrink, often result in more conservative behavior than initially expected. In other words, the plane’s turbulence always feels worse when you’re mid-flight rather than anticipating it on the ground.

Actionable Steps to Determine and Manage Your Risk Tolerance

Understanding that your actual risk tolerance might differ from your perception is the first step. Now, let’s explore some practical ways to assess your true risk tolerance and align it with your investment strategy:

1. Take a Comprehensive Risk Assessment

While most investors start with a basic risk questionnaire, it’s important to go deeper. Look for assessments that not only ask how you feel about losses in theory but also consider your financial situation, goals, and past reactions to market downturns.

2. Evaluate Past Behavior During Market Declines

Think back to market events like the 2008 financial crisis or the 2020 pandemic crash. How did you feel? Did you want to sell your investments? Your reaction to these moments can be a better gauge of your true risk tolerance than hypothetical scenarios.

3. Start Conservatively and Adjust as You Gain Experience

If you’re new to investing, it can be helpful to start with a more conservative portfolio. As you become more comfortable with market fluctuations, you can gradually adjust your asset allocation to increase your exposure to higher-risk, higher-reward investments.

4. Consider Your Time Horizon and Financial Goals

Your timeline plays a critical role in determining how much risk you can tolerate. If your goals are short-term (less than five years), you’ll likely want to be more conservative. For long-term goals, such as retirement, you can afford to take on more risk, knowing you have time to recover from downturns.

5. Work With a Fee-Only Financial Planner

A financial planner can help you understand your risk tolerance, align it with your goals, and build a portfolio that reflects your true comfort level. They can also provide guidance during turbulent markets, helping you stay focused on the long term.

Bringing It All Together

Understanding your risk tolerance is more than just filling out a questionnaire—it’s about preparing for how you’ll actually feel and react when the markets turn volatile. The truth is, most investors are more conservative than they think, especially when faced with real losses. That’s why building an investment strategy that aligns with your true tolerance is key to long-term success.

A well-defined risk tolerance, paired with a personalized financial plan, allows you to stay the course and achieve your financial goals, even when the ride gets bumpy.

Ready to assess your true risk tolerance and build a strategy that keeps you grounded during market turbulence? Contact us today to schedule a consultation and gain peace of mind for your financial future.