Reality is subjective. That might sound odd, as most believe reality is what it is. It’s not up to us to argue with facts.

But consider this: temperatures in the Midwest are expected to reach triple digits again this week. You won’t be judged here if you admit to daydreaming about that first crisp fall day and some combination of pumpkin-spiced lattes, Oktoberfest beers, and football. 

Our perception of a hot day changes with the seasons. In winter, a hot sunny day sounds amazing. But in a summer heatwave, the same temperature feels unbearable.

Depending on the circumstances, what’s real doesn’t always feel constant. Our perceptions often determine what’s “real” to us in any given moment — and those perceptions can change over time or depending on context. 

How Context Affects Our Investment Perceptions

This shift in perception happens with investments too. Understanding risk tolerance is crucial for long-term investing success, which is why risk tolerance questionnaires like this one are popular. They aim to gauge what market conditions might make an investor stray from their plan. 

This knowledge is crucial, given that the biggest risk for long-term investors is pulling money out of the market at the exact wrong time because of market fluctuations. 

However, just like our feelings about a hot day change depending on whether we’re in the middle of winter or a summertime heatwave, our perceptions of risk are not fixed. They change based on the circumstances as well.

Your Risk Tolerance Changes Over Time 

Consider March 2009. The S&P 500 had declined by over 50% during the Great Recession. Investors were scared, many fled the market, and those who remained wondered how much further stocks would fall. Imagine completing a survey of your risk tolerance in these market conditions. How do you think you would score? 

Now, fast-forward to today. The S&P has already hit over 20 new market highs this year and is up more than 50% since October 2022. If you took the same survey now, your score would likely look a lot different than in March 2009. 

This illustrates the problem of relying too heavily on risk tolerance questionnaires to determine how to invest. How you feel about risk is not a fixed trait. It can—and likely will—change over time. 

Discovering Your True Risk Tolerance 

In evaluating your tolerance for risk, a good place to start is the old adage, “You’re never as good as your best day or as bad as your worst day.” 

Most investors aren’t as risk-averse as they think they are in times like March 2009. But they’re also not as tolerant of risk as they might believe after a market run like the one that’s been going on for nearly two years.

So, how do you find your real risk tolerance? Start with these tips:

1. Self-Awareness – Recognize potential pitfalls. Understand that you might be tempted to reduce risk in down markets and increase it in up markets, and avoid acting on these instincts blindly.

2. Evaluate Risk Tolerance Periodically –  Since your tolerance for risk can change, periodically assess it to spot trends or shifts. Life changes like age, death, divorce, or job loss can also influence your feelings over time.

3. Think in $, Not %: Risk tolerance questionnaires often ask if you would stay invested if you lost 10%, 20%, or 30% of your portfolio. But that doesn’t feel real because we use dollars to buy groceries and pay bills, not percentages. If you have $500,000 invested, would you stay invested if you lost $50,000, $100,000, or $150,000? Thinking in real dollars can elicit the same emotion you may feel when markets are falling, giving you a better read of your true tolerance for risk. 

4. Have an Action Plan or a Non-Action Plan: Just like sports teams create game plans, investors should create a financial plan to navigate the ups and downs of the market and their lives over time. Write down the actions you will take (and won’t take) during the next market decline. For example, commit to rebalancing your portfolio and looking for buying opportunities but avoid panic-selling. Having a plan increases your chances of success when the pressure is on.

Much like our perception of a hot day changes if we consider the question in the dead of winter or the dog days of summer, our feelings about taking risks fluctuate too. Risk tolerance isn’t static, so taking one questionnaire once isn’t enough to understand your true comfort with your portfolio.

By considering these tips, investors can get a better feel for owning the right balance of stocks and bonds in their portfolio. This will help them stay the course during the next market rollercoaster, which is the most important goal for long-term investors in achieving their financial goals.

Castle Quote: “Risk and time are opposite sides of the same coin, for if there were no tomorrow there would be no risk.  Time transforms risk, and the nature of risk is shaped by the time horizon: the future is the playing field.” – Peter L. Bernstein