Every trader enters the market with a certain level of risk tolerance – a measure of how much potential loss they are comfortable accepting when making trading or investment decisions. Having a good understanding of one’s risk tolerance is crucial, as it informs many important aspects of a trader’s approach and strategy. Those who misinterpret or overlook their genuine risk tolerance run the risk of taking on more risk than they can bear mentally or financially. In this article, we will go over the notion of risk tolerance in further detail and explain why properly identifying and utilizing it is critical for trading success.
Factors That Influence Risk Tolerance
Several important factors help shape an individual trader’s risk tolerance:
Time Horizon – How long are you planning to hold positions? Generally, the longer your time horizon, the more risk you can tolerate. Day traders have very little time for positions to work out, while long-term investors can withstand more short-term volatility.
- Financial Goals – Are you saving for retirement decades away or trying to make a quick gain? Near-term financial needs mean less risk is advisable. Distant goals provide more time to recover from losses if needed.
- Age – Younger traders can usually handle more risk since they have decades left in the workforce to recover from losses and benefit from compounding gains. Risk tolerance tends to decrease with age.
- Account Size – Risk tolerance scales with portfolio size for most. A 2% loss on a $10k account hurts more than the same percentage loss on a $1 million account.
- Experience – Novice traders tend to overestimate their risk tolerance, while seasoned pros have a cooler head and a better understanding of risk. Experience moderates expectations.
- Personality – Some are born risk-takers; others are more risk-averse. It’s important to be self-aware of innate tendencies. Discipline can compensate for higher tolerance.
Assessing Your Personal Risk Tolerance
Questionnaires developed by financial experts can help traders quantitatively assess their risk tolerance. They present hypothetical scenarios involving different degrees of potential gains and losses to gauge comfort levels. It may be revealed that one’s self-perception does not align with actual tendencies under stress.
Another method is to examine past trading behavior. Were gains locked in quickly or let to run? How were losses handled – cut immediately or allowed to worsen? Consistent patterns provide clues to true tolerance. A journal tracking trades, reasoning, and emotions assist this reflection.
Overall, an accurate understanding of personal risk threshold comes down to self-knowledge, experience over time in different market environments, and objective analysis of behaviors and preferences in stressful situations. Formal assessment helps inform the qualitative self-examination.
Matching Your Strategy to Risk Tolerance
Once tolerance is established, it informs several vital aspects of a trading plan and approach:
- Position Size – A 1% position size may be appropriate if the strategy has 10% daily swings but is far too risky if moves are normally 3-5%. Position sizing scales with strategy volatility and tolerance.
- Holding Period – Day trading, swing trading, position trading – the strategy chosen should mesh with your comfort holding positions for the associated lengths of time.
- Trade Types – Highly leveraged futures may be too much for most but fit others. Similarly, day trading options require steadier nerves.
- Sector/Market Exposure – Some markets like cryptocurrencies see absurd daily moves that test even strong risk tolerances. Consider your limits.
- Diversification – Overly concentrated portfolios violate typical risk tolerance standards. Diversifying across multiple assets, sectors, timeframes, and strategies reduces overall risk.
Without aligning strategy to limits, fear or greed will subvert decision-making during drawdowns, increasing long-term losses. Understanding and respecting risk tolerance prevents costly mistakes.
Cutting Losses and Letting Profits Run
A core principle of effective risk management is cutting losses promptly while letting profits continue growing. But these behaviors require discipline that goes against human nature for many. To implement it successfully, risk tolerance must be considered:
- Those with low tolerance should exit losses quicker to avoid distress. Tighter stops protect mental/financial well-being.
- Conversely, high-tolerance traders can trail stops loosely and watch drawdowns with equanimity as they wait for reversals.
- Profits often are not taken until a specific gain target is reached, not simply because an arbitrary percentage is attained. Tolerance dictates reasonable gain objectives.
Proper evaluation of risk tolerance allows for setting stop losses and profit targets personalized to each trader’s specific situation and personality. This minimizes rash decisions during emotional moments.
Adjusting Risk Tolerance Over Time
In the beginning, accounts are smaller and experience more limited. Accordingly, early risk tolerance tends toward the conservative side for new traders. But as skills, psychology, and capital reserves improve, natural growth in tolerance should be expected. However, expanding limits sensibly requires ongoing self-evaluation:
- Reflect regularly with updated tools to ensure tolerance adjustments are warranted by actual capacity, not just performance chasing.
- Modest step-function increases in limits are safer than sudden leaps, especially after long winning runs that distort judgment.
- Pay heed to any hesitance or unease felt – intolerance signals are trying to convey an important message about personal risk parameters. Forcing limits and higher risks ruin.
- External reviews with experienced traders/coaches help confirm a trader’s self-assessment and planned changes are prudent or reveal any self-delusion creeping in. Outside perspective provides valuable checks.
- Be ready and willing to promptly reset limits downward in response to market regime shifts, strategy changes, or periods of underperformance if they call tolerance levels into question. Flexibility is key.
For many, a career-long, gradual raising of properly managed risk tolerance standards occurs naturally over decades. But forcing the issue often backfires, so patience and self-awareness are paramount.
Conclusion
Personal risk tolerance must be part of any serious discussion about trading strategy, money management, or long-term performance. Disciplined traders may avoid many of the behavioral problems that so many part-time or rookie market players fall into by developing a clear awareness of natural tolerance levels and how to apply them correctly to a trading system. It is one of the most important yet underappreciated topics for aspiring traders looking for an advantage. With careful self-evaluation and adaption over time, risk tolerance may become a valuable strategic and psychological advantage.
