Risk tolerance is an innate psychological trait.
It can be positively influenced by income, education, and wealth (an increase in these factors has been shown to increase risk tolerance).
And negatively influenced by age (as a person ages, one’s risk tolerance decreases).
Risk tolerance refers to how you regard risks and the level of anxiety you feel have when there is risk involved.
You can view it as “how much one is willing to expose themselves to a less favorable outcome in favor of a more favorable one”
For example, will you risk $10 for a chance to win $100? Or $10 to win $10?
There is no ‘correct’ risk balance as this varies from one person to another.
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The perception of the risks by the person can affect risk tolerance. A good example is, in the early 1900’s it would have been very risky to fly an airplane or ride a car, but today it is not perceived that risky because flight and automobile travel are common occurrences. Likewise, riding a horse today can be seen as being dangerous because there is a chance of falling down because few are exposed to horseback riding.
The idea of perception is key, especially when it comes to investment.
The more knowledge you gain about the stock market, the more you will consider stock investments as something that has lower risk.
This will result in a lesser degree of anxiety when you invest. In this case, your perception of risk has changed your level of risk tolerance to stocks.
Knowing your risk tolerance allows you to be in a better position to avoid investments that make you anxious.
It is always a good idea to avoid owning an asset that will keep you from sleeping in the night. Anxiety will stimulate fear which will then trigger emotional response (rather than a logical response) to what is causing the stress.
It also helps to understand the risks you are exposed to when investing and what is a realistic level of risk associated with different investment options.
The investors who come ahead during the times of financial uncertainty are the ones who retain a cool head and follow their analytical decision process.