I would offer a couter-point to the folks who say you should base your investing risk tolerance on how you would feel in the face of a large market drop. I think this is basically emotional investing. And, in my opinion emotional investing is wrong. Emotions change, people feel terrible at the bottom during an economic contraction and feel invincible at the top of the market.
I would say: Would you objectively be able to survive an economic crisis ...
Yes and no. If you are a rational person, the bad "feeling" will be based on objective criteria. If you are an emotional person, you need to consider your emotions when determining risk tolerance. Being objectively save helps nothing if you panic anyway and sell everything.
No. If someone is a rational person, they will place their feelings to the side and will rationally analyze a situation in a businesslike manner. Some of the best trades I made so far felt bad. But, when I did the math -- whole sector funds trading below book value, or at or less than 10-11 P/E -- I decided everyone else was likely over-reacting to the bad situation, and that it was a good time to buy.
If someone is prone to panic, then they should learn to not panic. Emotions are reptilian-brain responses to situations -- It is possible train ones self to get emotions under control when they objectively serve no useful purpose.
Who is this rational human you speak of? I've never met such a person.
IMO the risk we are talking about is the risk we will sell shares during a correction. Everything else is actuarial data (FWIW, a 90/10 portfolio had the best survivability and growth, historically). The way we feel while going through a downturn is directly relevant to the behavior that occurs. The concern is we commit to a 100/0 or 90/10 portfolio several years into one of the biggest bull runs in history, and then freak out when a routine recession or 25% correction occurs and change our minds to stop the losses before it gets worse.
Yet, I don't agree with the "how would you feel if the market dropped 50%" advice. I feel like crap when the market drops 5%. That drop represents months of my youth spent in a cubicle! This advice would put me 100% in bonds.
The question is how bad the losses could get until you break discipline and panic.
I've heard numerous combat veterans tell the story of the tough guys/badasses who talked like they were Rambo on base but cracked the first time actual bullets started flying and froze up/cried in the middle of their first battle. These soldiers should have gotten civilian jobs, but they didn't know or understand themselves well enough at the time.
Picking a risk tolerance is an attempt to not be that guy. Yet for investors there is no psychologically abusive boot camp to help us find our breaking points or sort out the people destined to run away when the bear attacks. If you haven't lived through it, there's no way to know.
My comfort strategy is to have a plan of counterattack and rehearse it. S&P down 10%? Switch from the S&P to the Nasdaq. Down 20%? Look for beaten down leveraged/high-beta stocks. Down 30%? Trade bullish LEAP options. Down 40%? Move in with a friend, eat nothing but beans, rice, and frozen veggies. Work 80 hour weeks and plow at least 80% into LEAPS while the good times last.