Decide this before deciding what you want to earn
New investors usually start with a return target, such as earning a certain percentage a year. But what ends most investment plans is not missing that target; it is a loss too large to tolerate. Selling in a panic after a big drop often locks in the loss and leaves you out of the recovery.
A risk budget decides first how much you could lose and still stick with the plan, then divides assets within that limit. This guide explains how to define a tolerable loss, how to see where risk is concentrated, and how to stress-test a portfolio, using a hypothetical example.
What a risk budget means
Investor.gov describes risk as the possibility of losing some or all of the money you invest, and notes that seeking higher returns generally means accepting more risk. A risk budget treats that risk as a limited resource: you set the total amount of risk you can take and decide how to allocate it across assets.
Risk here means more than a statistic such as volatility. It includes when you will need the money, how stable your income is, and how you react emotionally to losses. The same portfolio carries very different risk for someone buying a home next year and someone retiring in twenty years.
Start with the loss you can tolerate
The starting point is to write down, in money rather than percentages, how much you could lose in a bad year without changing your plan. With $100,000 invested, that might be "I can live with a $30,000 loss."
Next, consider what that loss would mean in practice. Is there a separate emergency fund? Is money you will need within a year or two mixed into the investments? As a rule, money needed soon should not be part of the risk budget at all.
Risk contribution in a hypothetical portfolio
The table divides a hypothetical $100,000 portfolio among stocks, bonds, and crypto. Alongside the weights, it shows where risk is concentrated and what a severe downturn would cost. Risk contribution is calculated simply as weight times volatility, ignoring correlations.
| Asset | Weight | Assumed annual volatility | Simple share of risk | Stress assumption | Stress loss |
|---|---|---|---|---|---|
| Stocks | 60% | 18% | ≈ 55% | -35% | -$21,000 |
| Bonds | 30% | 6% | ≈ 9% | -5% | -$1,500 |
| Crypto | 10% | 70% | ≈ 36% | -70% | -$7,000 |
| Total | 100% | - | 100% | - | -$29,500 (-29.5%) |
Crypto is only 10% of the money but about 36% of the risk. The stress loss of $29,500 sits right at the $30,000 tolerance set earlier.
Stress-testing the plan
The stress assumptions can be informed by how far each asset fell in past severe downturns. The point is to plan around a bad year, not an average one. Assets that usually move differently often fall together in a crisis, so it is safer to assume little diversification benefit in a stress test.
If the stress loss exceeds what you can tolerate, reduce the riskiest holdings even at the cost of a lower expected return. If there is plenty of room, you may have scope to take a little more risk. Investor.gov's asset-allocation guidance likewise recommends matching allocation to your time horizon and risk tolerance.
Common misreadings
"A small weight means small risk" fails for highly volatile assets like the crypto in the table, where 10% of the money carries more than a third of the risk.
"Risk tolerance is set once" is also wrong. Age, income, family circumstances, and the size of the portfolio all change what you can afford to lose. After a portfolio has grown a lot, the same percentage loss is a much larger amount of money.
Recording and reviewing
A risk budget is a plan to revisit, not a decision to file away. Record the following.
- Write down, in money, the loss you could tolerate in a bad year, and exclude money needed within one or two years.
- List each asset's weight and rough volatility to see where the risk is concentrated.
- Set stress assumptions for each asset based on past severe downturns and calculate the total loss.
- Adjust weights so the stress loss stays within your tolerance.
- Review the tolerance and the weights once a year, or whenever income or family circumstances change.
Limits of a risk budget
Stress assumptions are estimates drawn from the past, and the next crisis may be worse. Volatility and risk-contribution calculations are simplified models that will differ from reality.
The portfolio and figures here are hypothetical and are not personalized advice. Base your own allocation on your financial situation, and consult a professional if needed.