What is risk tolerance?

Definition and Example of Risk Tolerance

All investments carry a certain degree of risk. Risk tolerance is the ability to withstand market risk. Simply put, it is how much risk you are willing to take and how much money you are willing to lose in exchange for potential profit. For example, if you are unwilling to lose much, or anything, of your invested capital, then you have a very low risk tolerance. If you don’t mind risking some of your money for the chance to make significant gains, then your risk tolerance will be higher.

How Risk Tolerance Works

You can estimate your risk level using an online calculator or by talking to a financial advisor. Financial advisors use risk tolerance to adjust the financial advice they give. They can also use risk tolerance to determine investment patterns for their clients, whether they are aggressive, moderate, or conservative. Companies use these three categories as a simplified way to describe asset options and suggest asset allocation or offer strategies to their clients.

Types of Risk Tolerance

On a scale from least to most risky, there are three categories of risk tolerance:

• Conservative: If you have a conservative risk tolerance, you will prefer feeling secure in how you choose to invest. Instead, you will prefer to avoid the risk of loss rather than take a chance on making significant gains. People with this investment profile tend to be older and less wealthy than others.
• Moderate: You can take on some risk, but within certain limits. You may be willing to lose part of your money for the chance at significant gains but do not want to risk more than you can afford to lose.
• Aggressive: You can take big risks. You can tolerate volatility and significant fluctuations in values and prices. You can achieve big wins, but you can also face big losses.

What Does This Mean for Individual Investors?

Every investor needs to determine their risk tolerance before choosing investments. With this knowledge, you will gain a better understanding of the types of investments that align with your comfort level and those you should avoid. Otherwise, it is difficult to build a portfolio that fits your profile and meets your goals.

Although risk tolerance is a vital part of any financial plan, many people do not take it into account as much as they should. If you misestimate your risk tolerance or act against what you know about yourself, problems can arise.

Many investors make the mistake of thinking they have a high risk tolerance when they actually do not. Then, when the stock prices in their portfolio drop significantly, they panic and sell their shares instead of riding out the market wave. Simply put, they cannot bear the thought of their investments losing even more value. Their willingness to take risks is less than they thought.

It’s difficult to control your actions in the face of turmoil. Understanding your true risk tolerance will help you be realistic so that you can make the right choices from the start instead of feeling regret and correcting them later.

By being aware of your risk tolerance and building a portfolio that takes that into account, you can avoid giving up on your financial goals by selling investments or making decisions based on emotional reactions due to market fluctuations.

Source: https://www.thebalancemoney.com/what-is-risk-tolerance-2466649