What does 'risk tolerance' refer to in investments?

Risk tolerance specifically refers to the degree of variability in investment returns that an investor is willing to withstand. It encompasses the emotional and psychological capacity of an investor to endure fluctuations in the value of their investments without making impulsive decisions, such as selling assets during downturns. An investor with high risk tolerance may accept significant fluctuations in the market for the possibility of higher long-term returns, while an investor with low risk tolerance may prefer more stable, lower-yielding investments to avoid the stress of significant losses.

Understanding risk tolerance is crucial for investors because it helps in aligning their investment strategy with their comfort level regarding potential losses and gains. This alignment is essential for maintaining a consistent and disciplined investment approach. It helps in selecting the appropriate asset allocation and investment products that match the investor’s psychological and financial capacity for risk.