If you’ve ever seen someone bungee jump off the side of a bridge, you’ve probably had one of two thoughts: “That looks like fun!”… or, “That’s the terrifying thing I’ve ever seen!” Some people are risk takers, while others avoid risk like rancid milk. The level of risk you’re comfortable with is called your risk tolerance. It determines your attitude towards a lot of things in life – including your investment strategy.

Your risk tolerance level has a huge impact on your investment decisions – and how much money you make and save. So understanding your personal risk tolerance is key to becoming a better investor.

Risk tolerance factors

It might be tempting to give a vague answer to this question. But you need to find a more specific answer than “I think I can tolerate some risk.”

Risk tolerance is determined by looking at two factors – the willingness to take a risk and the ability to take the risk.

Let’s start with ability. That’s the most measurable factor of the two.

Your age and wealth can help you decide how much risk you can assume. If you’re young and have more money than average people your age, you have the ability to take more risks than average. It doesn’t mean you have to take on more risk, but you could.

One reason is that younger investors have more time to recover from bad investments. Or they have the time to allow an investment to go through a series of ups and downs before they need the money. Younger investors have a longer time horizon and can experiment a lot more. If you take a severe loss on any investment, you have more than enough time on your hands to recover.

On the other hand, someone a few years away from retirement would probably not want to invest their retirement fund in a risky, speculative investment. If the investment doesn’t pay off, they don’t have the time to make the money back before they need it for retirement.

Your ability to take on risk is also a function of your net worth. If you have $1 million, investing $20,000 in your friend’s tech start-up may not be a big deal. That’s only 2% of your overall portfolio, so if it doesn’t work out it won’t be too devastating to your bottom line.

But if that $20,000 is your entire life savings, then investing it all in your friend’s business is a terrible idea. That’s because you could lose 100% of your savings, instead of just 2%.

The other risk tolerance factor is a willingness, and that’s a lot less tangible.

Some people cannot handle the thought of losing any money – regardless of how much they already have. Others may have made a bad investment decision in the past and are so traumatized that they want to avoid risk at all costs. Willingness is also determined by cultural attitudes.

If you lose sleep worrying about how a riskier investment is doing, or if you feel physically ill if your investment statement shows a loss, you probably have a low willingness to take on risk.

Willingness and ability don’t always match

Even if you have the ability, you may be unwilling to take on much risk. Alternatively, you could be a fierce risk-taker who’s willing to take a long shot and shoot for the moon, but you are limited by your ability – perhaps because you simply don’t have the capital.

Willingness and ability are, often, mismatched. The best you can do is use your ability as a benchmark. If you have the ability to take a loss on a potentially risky investment, then go ahead. But if you don’t, the prudent thing to do is to take fewer risks than you would have otherwise.

Here’s a chart that can help you visualize this concept:

One way to figure all this out is to answer a questionnaire designed to determine risk tolerance, like this one from Yahoo Finance. It has ten basic questions and by the end of it, your score will put you in a risk tolerance category, from low to moderate to aggressive.

How does knowing your risk tolerance help?

Knowing your risk tolerance level can help you decide how to shape your portfolio. You may already know you shouldn’t put all your eggs in one basket, but risk tolerance will help you determine which types of eggs to put in which basket.

Young, wealthy investors with a high tolerance for risk have more ability and willingness to invest more in stocks and emerging market funds. Older investors who are less financially secure may only have the ability and willingness to put more of their assets into fixed income funds and bank deposits.

Risk tolerance is a crucial element that must be considered when building an investment portfolio. A portfolio can only be considered well-balanced if it meets your specific risk profile and helps you achieve your goals over the long term.

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