Risk tolerance is how much investment volatility a person is psychologically willing to accept. It is a disposition, and it is measured by asking — which is why it is the easiest of the three risk dimensions to capture and the least reliable on its own.
Tolerance is a genuine input. A client who cannot sleep holding a portfolio will not hold it, and a plan that ignores that is a plan built for someone who does not exist.
Tolerance is measured in a calm room with no money moving. The respondent is imagining a loss rather than experiencing one, and people are reliably bad at predicting how they will feel about something they have not felt yet.
The answer also moves with the market. The same person scores differently in a rising market than in a falling one, which means the score partly measures when you asked.
Risk capacity is arithmetic — how much loss the plan can absorb before it stops working. Tolerance has nothing to do with it. A client can be perfectly comfortable with a level of risk their plan cannot survive, and the reverse is at least as common.
What someone does in a drawdown is a third thing again. Tolerance is stated; behaviour is revealed. They correlate less well than the category assumes.
Tolerance answers what someone is willing to sit through. It does not answer what they can afford, or what they will actually do.
Read next
Risk capacity →