Risk Tolerance vs Risk Aversion

Risk is a part of everyday life. When we drive to work in the morning, we know there is a slight but real risk of being injured in a car accident—but we accept the risk because our desire for the consequences (getting to work) outweighs our fear of the potential disaster.

Risk is a part of investing, too. In fact, we could say that risk is what separates investment from saving: when you invest, you accept the risk that you will lose your money (or at least, that you will not make money) in return for the potential of making more money than you could if your capital was building up in a passbook savings account (or under your mattress). This is the well-known risk-return tradeoff: the riskier an investment is, the higher its potential return should be. Conversely, investments with very little risk typically offer lower returns.

Risk-averse investors will take on only as much risk as they deem necessary to get the investment return they desire.

For skydivers and casino gamblers, risk is part of the thrill. But investors (serious ones, at least) are looking to make money, not lose it. A rational investor is risk-averse: he or she wants to avoid risk, but realizes it is necessary to achieve a return. Therefore, risk-averse investors will take on only as much risk as they deem necessary to get the investment return they desire. Risk-averse investors also wish to maximize the returns they get for the level of risk they take on.

As a result, the amount you can expect to make on your investments is largely determined by how much risk you can take on—in other words, on your risk tolerance. To some extent, risk tolerance is an emotional issue. If you are petrified of losing your money, you are not likely to invest it. However, it is more useful to think of risk tolerance in terms of the financial consequences of losing your investment capital in the stock market today, or of placing your capital in poorly performing investments.