What Is Risk Tolerance

Simply put, risk tolerance is the degree of volatility or variability in investment returns that an individual is willing or able to withstand. Risk tolerance is an important component in investing and an individual should have a realistic understanding of his or her ability and willingness to stomach large swings in the value of his or her investments. Investors who take on too much risk are in danger of seeing their investments decline at just the wrong time (for example near retirement) or may sell at the wrong time.

There is no one definitive way in which Investors can assess their degree of risk tolerance. The best way is to obtain the best education possible regarding one's current investments and the risks associated with them and then combine that with a realistic assessment of how much risk he or she is really capable of taking on. There are a number of different risk tolerance questionnaires, but in reality, one's life experiences and how he or she has reacted to different events is probably the best way to assess risk tolerance. For example,if you ever lost money in the stock market, think about how you felt and how you reacted. Then apply that to your current situation to get a reasonable idea of how much risk you should be exposed to at this particular time of your life.

In addition to the above, it is essential to take into consideration the purpose of a particular investment. Is it a retirement account or college funding vehicle........or are you saving for that boat you always wanted.  It can be useful to review worst-case returns for different asset classes historically in order to get an idea of how much money one would feel comfortable losing if his or her investments have a bad year or bad series of years. Then consider that potential loss in relation to the importance of the particular investment. 

Other factors affecting risk tolerance are the time horizon that one has to invest, future earning capacity, and the presence of other assets.