Posted:December 4, 2025
Categories: Risk, Risk Management
Risk. What is it? This is a topic I think about daily. Let’s begin with the definition of risk from Webster’s 1828 Dictionary:
“In commerce, the hazard of loss, either of ship, goods or other property. Hence, risk signifies also the degree of hazard or danger; for the premiums of insurance are calculated upon the risk.”1
The definition of risk above concerns the loss of property. In the 1800s, risk meant loss of property. For individuals, this may have meant a bad crop, a precipitous drop in commodity prices, bank failures, theft, etc. For merchants, shipping risks were extremely high due to the perils at sea, human factors, and slow communication. Believe it or not, leverage, that is, the use of debt, was common even back then. And there was no central bank bailout to count on.
In this article, I’m focusing on what risk looks like when investing in today’s more financialized, debt-based monetary system. In this context, “risk” refers to the chance that an investment portfolio will lose value. We all take risks every day, but it’s not often that we step back and analyze risk before we experience it.
Let’s also define two more terms: risk tolerance and risk capacity.
Risk tolerance is a subjective measure referring to the amount of risk we’re willing to accept emotionally. Can you take a 25% drawdown (decline) in your stock portfolio without losing sleep or making a panic-driven decision at the wrong time? This is risk tolerance.
Risk capacity is an objective measure referring to the amount of financial risk we can take on. A 25-year-old just starting work has a higher capacity to take on risk. A retiree living on cash flow from a portfolio or a fixed income has a lower capacity for risk.
Assessing Risk
One of the most important roles I play in helping people manage money is properly assessing each person’s risk tolerance and risk capacity. This is easy to say, but hard in practice. Every person makes risk decisions differently. It’s actually quite fascinating and is one of the most challenging and enjoyable parts of my job. If I assess well, I’ve accomplished a critical part of my job. Having a long-term understanding of risk helps, especially when clients experience a portfolio’s value drop during a bear market, or a client’s circumstances change, such as a fluctuation of income or simply getting older.
The most challenging aspect of assessing someone’s risk level is at the outset of a relationship. I can give anyone a risk questionnaire, and often do, but I’ve found these are somewhat limiting. I find it very helpful when I can see their current portfolio asset allocation, as this will tell me much more. However, I’ve found that having an in-depth conversation, preferably in person, is the best way to get a well-rounded perspective on a person’s risk preferences.
Seven Levels of Risk
Consider seven levels of risk and how each negative outcome affects our level of wealth. I’ve adapted these levels from Andy Constan’s work.2 He emphasizes that investors should attempt to set a risk target or, in this context, identify a preferred “risk level.” This risk level will help establish a properly diversified portfolio, risk/return objectives, and an awareness of potential maximum drawdown. A maximum drawdown refers to the decline in the value of a portfolio from its highest point to its lowest point.3
LEVEL 1: Negligible Change: The change in a portfolio’s value is routine and has no impact on overall wealth.
LEVEL 2: Tolerable Discomfort: A small drawdown of a portfolio that confirms an acceptable level of risk.
LEVEL 3: Tested Conviction: A larger drop in a portfolio’s value causes frustration, but no major pain or loss of wealth.
LEVEL 4: Substantial Drawdown: A significant drawdown in a portfolio’s value, causing worry and loss of sleep.
LEVEL 5: Pain-Driven Action: A severe wealth destruction event causes an urgent, powerful need to exit the market, regardless of the financial consequences of realizing the loss.
LEVEL 6: Life Changing Loss: Requires a large-scale, lasting reduction in living standards.
LEVEL 7: Financial Ruin: The loss is so severe that it causes financial ruin, eliminating all hope of recovering the original quality of life.
Mind the Middle
Let’s get the worst out of the way first. Levels 6 and 7 are events that no one wants to experience. These catastrophic events are generally hedged against through the purchase of insurance (e.g., life, health, home).
However, in the context of investing, a level 5 event can quickly cascade into a level 6. As a student of financial history, I am keenly aware that there is always a risk of a large financial bubble popping, leading to a financial crisis and sharp market declines. These markets can easily trigger a level 5 or 6. In fact, early in my career, some of my clients experienced a level 5 event through the 2008/2009 Global Financial Crisis.
“Monday, September 15, 2008, created a lasting memory in my brain. The Federal Reserve failed to rescue and bail out Lehman Brothers the previous weekend. The stock market opened to a sea of red, with markets plummeting. Volatility ensued, and the S&P 500 continued dropping until what seemed like an eternity, bottoming out at a devilish 666 on March 6, 2009. I vividly remember this period, and much of the experience and lessons learned from the global financial crisis (GFC) laid the groundwork for how I manage money today.”4
In summary, levels 2 through 4 are the sweet spot for most investors. Enough risk to profit from a healthy stock market and enough protection to avoid massive losses. However, investors comfortable in levels 2 through 4 should always be aware and even expect a level 5 event due to our current debt-based monetary system, which has become more fragile over time. Pre-deciding not to take adverse actions in down markets is one defense. Another defense is properly designing a portfolio’s risk and return objectives commensurate with your stated risk tolerance and risk capacity. A simple, efficient, and diversified portfolio design can go a long way toward stable, steady returns with controlled downside risk.
References
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