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How to understand and assess your risk tolerance
KEY FINDINGS
- Risk tolerance measures how much investment uncertainty you can emotionally handle.
- Risk capacity measures how much financial loss you can realistically afford to absorb.
- According to experts, most individual investors tend to overestimate their ability to tolerate market downturns before experiencing real losses.
- Major life events such as marriage, parenthood, homeownership, or retirement can change your risk profile.
- A suitable investment strategy typically should align with both your risk tolerance and risk capacity.
Updated on July 23, 2026 by Arshi Hossain | Originally written February 20, 2025
Risk tolerance reflects how much investment uncertainty and potential loss you are emotionally comfortable accepting in pursuit of higher returns. It is shaped by your personality, life experience, and response to past market downturns. This differs from risk capacity, which measures how much loss you can financially afford.
Most investments carry a certain amount of risk. Before you make any type of investment, it is advisable to first determine your own comfort level when faced with financial uncertainty. Experts suggest working with a professional advisor to align your portfolio with your ability to handle market volatility.
What to consider when evaluating risk tolerance?
When evaluating risk, Sadiq Adatia, chief investment officer (CIO) at BMO Global Asset Management (BMO GAM) considers three dimensions: risk tolerance (which investors frequently overestimate), the actual ability to handle risk (which people often underestimate), and the net amount at risk.
“It's common for individuals to become more anxious about potential losses as their assets grow (i.e., more to lose), even though their capacity to absorb losses usually increases along with their wealth," Adatia says. Anxiety tends to grow the longer the challenging period lasts.
In practice, investors express confidence in staying invested during downturns but struggle when faced with real losses, says Stuart Morrow, investment counsellor at Mawer Investment Management Ltd., and part-time professor at Toronto Metropolitan University’s Ted Rogers School of Management.
Historically, extended periods of strong market performance, such as long stretches of gains with relatively brief drawdowns since 2008, “can create a false sense of comfort with volatility”, Morrow adds.
Both Adatia and Morrow agree that most individual investors tend to overestimate their risk tolerance.
What factors determine risk tolerance?
Risk tolerance is often used as a catch-all term, but it’s one of three distinct concepts: Risk tolerance, risk capacity, and risk perception.
- Risk tolerance: Your emotional comfort with uncertainty and market volatility. It's subjective and shaped by factors such as personality, life experiences, and how you respond to loss.
- Risk capacity: Your financial ability to absorb losses without jeopardizing your goals. It’s objective and depends on factors like your income, savings, debt, dependants, and investment time horizon.
- Risk perception: How risky you believe an investment is—which doesn’t always align with reality. Investors often underestimate risks in familiar investments and overestimate their understanding of complex products.
Together, these factors can help determine how much investment risk is appropriate for an individual.
The difference between risk tolerance and risk capacity
| Category | Risk tolerance | Risk capacity |
|---|---|---|
| What it measures | How much uncertainty you can emotionally handle | How much financial loss you can actually absorb |
| Nature | Subjective | Objective |
| Shaped by | Personality, life experiences, response to loss | Income, savings, debt, dependants, time horizon |
| Correlations | Risk tolerance can be high when risk capacity is low = potential for higher financial losses. Risk tolerance can be low when risk capacity is high = greater ability to absorb financial losses. | |
Source: Canadian Securities Administrators (CSA), Canadian Investment Regulatory Organization (CIRO)
What are common mistakes in determining risk tolerance?
Many investors misjudge their risk tolerance because they base it on hypothetical scenarios rather than real-life market experiences, according to Morrow.
While it may seem easy to accept a certain level of risk in theory, the emotional impact of actual losses can be very different. “Saying you are comfortable with a 20% decline is very different from experiencing a $200,000 drop in a $1 million portfolio over a short period of time,” he says.
Morrow says behavioural biases such as recency bias and overconfidence can cause investors to overestimate their ability to handle volatility. “Without proper framing and guidance, this often results in portfolios that are not aligned with an investor’s true ability to withstand volatility, which may in turn lead to making poor decisions at the wrong time.”
BMO GAM's CIO Adatia echoes the importance of professional guidance. He says one of the most frequent mistakes individuals make when assessing their own risk tolerance without professional guidance is neglecting to consider realistic scenarios—such as the magnitude of market downturns and the time it takes to recover.
“Professionals can offer concrete examples and draw on client experiences to provide a more accurate, independent assessment of where true comfort levels lie," Adatia says.
Both experts believe that younger investors often tend to misjudge their risk tolerance, despite their ability to take on risk due to smaller amounts invested, higher future earnings potential, and longer investment horizons.
"They [younger investors] often choose more moderate investment strategies, such as balanced portfolios, rather than embracing higher equity exposure that would be more appropriate for their situation,” Adatia says.
On the other hand, Mawer’s Investment Counsellor Morrow notes that investors who began investing during strong markets—such as the 2010s—may overestimate their tolerance because they have not experienced a prolonged downturn.
In his view, recency bias plays a major role and can lead to underappreciating the importance of diversification and disciplined rebalancing as portfolios drift over time.
"Personal history matters as well; family attitudes toward money and early investment experiences can shape how individuals perceive risk,” says Morrow.
How does loss aversion impact your tolerance to market downturns?
Loss aversion—a well-documented finding from behavioural economics shows that investors typically feel losses to be roughly twice as painful as the joy of equivalent financial gains.
According to Adatia, most people overestimate their risk tolerance. “When discussing market volatility in theory, many feel confident they could weather significant downturns. Yet, when these events actually take place, anxiety often sets in—especially if market turbulence persists over time.”
Clients who initially believe they can tolerate market volatility change direction once faced with real losses, Adatia says. “Often, they exit the market during significant declines, only to re-enter after a rebound—resulting in full participation in the downturn but only partial participation in the recovery.”
In Morrow’s experience, time invested upfront to understand clients’ goals, time horizon, liquidity needs, and prior experience with markets, can mitigate a material change of course during periods of market stress.
“We also place a strong emphasis on education—helping clients understand how markets behave and setting realistic expectations for volatility before it occurs,” Morrow says.
Learn more: Is debt consolidation right for you?
When does your risk tolerance matter beyond investing?
Your relationship with financial risk could show up in a much broader set of decisions:
- Choosing a mortgage type: Choosing between a fixed-rate and variable-rate mortgage is fundamentally a risk decision. A variable rate may save you money if rates fall, but rates can also rise—sometimes significantly and quickly, as many Canadian homeowners discovered during Covid-19 years. Your choice depends in part on whether you can absorb higher monthly mortgage payments, both financially and emotionally.
- Carrying debt vs. building savings: Prioritizing aggressive debt repayment over investing is typically considered a low-risk choice. The reverse could involve higher risk. Your approach depends on interest rates, access to emergency funds, and your psychology around debt.
- Career decisions: Leaving a salaried job to start a business may involve accepting income uncertainty and potentially higher risk. Freelancing, taking a commission-based role, or working in a new industry are also career decisions with potential future uncertainty.
- Insurance choices: Selecting a higher deductible in exchange for lower premiums could be considered a calculated risk. Whether that trade-off is worth the risk depends on your financial buffer when a claim occurs.
Your risk tolerance is a lens that applies anytime there's a financial trade-off between stability with lower returns vs. potential upside involving higher risk.
When should you update your risk tolerance?
Risk tolerance and capacity both evolve throughout life. Revisiting your thinking at life’s major milestones can be beneficial. Common triggers that warrant a risk reassessment include:
| Life event | How it may shift your risk profile |
|---|---|
| Getting married or moving in with a partner | New shared financial obligations and goals |
| Having a child | Increased financial responsibilities; income may temporarily drop |
| Buying a home | Large debt taken on; less liquid savings available |
| Career change or job loss | Income stability changes significantly |
| Receiving an inheritance | Risk capacity may increase; emotional relationship with money may also shift |
| Approaching retirement | Investment time horizon shrinks; risk capacity for loss typically decreases |
| Experiencing a significant market downturn | Reveals actual (vs. assumed) risk tolerance in real conditions |
Source: Canadian Securities Administrators (CSA), Canadian Investment Regulatory Organization (CIRO)
"When portfolios are thoughtfully constructed and aligned with a comprehensive financial plan, investors are far more likely to stay disciplined through periods of uncertainty,” Morrow says.
Read more: Ask the Expert: Kristine Beese on helping grown kids without risking retirement
How to invest with understanding your risk tolerance?
If you work with an advisor, under Canada's Client Focused Reforms, registered advisors are required by CIRO and the Canadian Securities Administrators to assess both your risk tolerance and risk capacity, and recommend investments suitable for the lower of the two. You can verify any advisor's registration at ciro.ca.
If you invest on your own, CIRO offers a free Investor Questionnaire as a starting point—however, it’s not a complete assessment.
If you're unsure where to start, the Financial Planning Standards Council maintains a directory of accredited Certified Financial Planners, including fee-only planners who charge for their time rather than earning commissions.
“Clients who work with advisors are more likely to stay disciplined and maintain their investment strategies, which typically leads to better long-term outcomes,” Adatia says.
Frequently asked questions
Is low risk tolerance bad?
No, low risk tolerance is not a financial flaw. A long-term conservative strategy can outperform an aggressive one you may abandon during a downturn. What matters is accurately understanding your risk tolerance while making financial decisions.
How does risk tolerance affect choosing between a fixed and variable mortgage rate?
The type of mortgage you choose depends on your financial cushion and income stability. A variable rate may cost less over time, but payments rise when policy rates climb. If that unpredictability could strain your monthly family budget, you would likely be more comfortable with a planned fixed-rate mortgage.
Does risk tolerance matter when picking an insurance deductible?
Yes. A higher deductible lowers your premium but could mean absorbing more costs if you make a claim. If an unexpected $1,000–2,000 payment would cause you financial strain, a lower deductible could be a better option for you.
If you have a substantial emergency fund, taking on risk of a higher deductible in exchange for lower premiums could be a reasonable trade-off.
Read next: Home equity in the age of a recession: How can it help?
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Arshi Hossain
Arshi Hossain, Associate editor
Arshi Hossain is the associate editor at Rates.ca. She has 4+ years of experience in delivering strategy-backed digital content through various mediums. Her expertise lies in breaking down complex information, meeting people where they are, and in the moments that matter.
Prior to joining Rates.ca, she worked in the editorial and digital content space at Wealthsimple, supported digital strategies, and UX writing for payment products and solutions at Bank of Montreal. She has also worked with startups to support editorial, content writing, communications, copywriting, and marketing needs.
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