Risk tolerance is an investing term relating to the amount of market risk, especially the volatility (ups and downs), an investor can tolerate. Usually gauged by a calculator or questionnaire, risk tolerance is often used to categorize investors as Aggressive, Moderate or Conservative.
Example and Caution:
For example, a risk tolerance questionnaire may ask several questions with various market scenarios and the investor will anticipate their reaction to the given market scenario and answer the questions accordingly. A sample question is, "What would you do if the stock market fell by 20% over the course of one year? Would you A) Do nothing, B) Wait a few months to make a decision, or C) Sell your stocks immediately.?"
An aggressive investor would likely answer 'A,' a moderate investor 'B' and a conservative investor 'C.' The intention of the questionnaire is to help the investor build a portfolio of investments that the investor will be comfortable with over long periods of time. Abandoning an investment strategy abruptly due to stock market activity is not usually the best reaction. Therefore a risk tolerance questionnaire should aid the investor by anticipating and preventing poor investing behavior.
Although it is wise to understand your tolerance for risk, keep in mind that your own behavior is difficult to predict in advance. Many investors make the mistake of believing they are "aggressive" but they are really "moderate," and when the stock portion of their portfolio falls dramatically in price, they may sell the stocks immediately even if their previously gauged risk tolerance suggested they would "do nothing."
A Word on Risk Capacity
Another aspect of risk tolerance is risk capacity, which is the amount of risk you can afford to take. This differs from the risk you are willing to take. In other words, you may be comfortable with an aggressive, high risk portfolio but, if you are only a few years away from your investment goal, such as retirement, you can’t afford to have a portfolio of 100% stocks; you need a more conservative (lower relative risk) portfolio to preserve the investment assets you'll need for retirement.
See Also: Market Risk