Risk Tolerance

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Risk tolerance is a psychological trait, i.e. a distinguishable, relatively enduring way one individual differs from another, and as such is amenable to psychometric testing. Psychometrics, a blend of psychology and statistics, is the science of test construction. Psychometric instruments measure such intangibles as attitudes, values, personality, intelligence, aptitudes, states and traits.

Risk tolerance (like many other human characteristics) is Normally distributed. When graphed, risk tolerance scores fit the familiar bell curve of the Normal distribution.

An individual is exposed to risk in any situation where there is uncertainty about at least one of the possible outcomes. Risk tolerance is the extent to which an individual is prepared to risk experiencing a less attractive outcome in the pursuit of a more attractive outcome.

Numerous research studies of individual and collective behaviour have been carried out internationally. While there are still areas of uncertainty about some of the finer details, there is broad agreement on the general nature of risk tolerance. Research has indicated four types of risk tolerance - ethical, social, physical and financial.

Individuals behave consistently within types but not between types. For example, hang gliding will correlate with mountain climbing but not with public speaking.

Within financial risk tolerance, there is no evidence of sub-factors, i.e. there is no evidence of there being, say, investment risk tolerance, employment risk tolerance, borrowing risk tolerance, etc.)

Unlike, say, height or weight, there is no physical unit of measurement for risk tolerance. An individual's risk tolerance can only be measured relative to others on a constructed scale in much the same way as IQ is measured.

An individual's risk tolerance will be a function of their 'nature' (in essence, what is genetically driven), 'nurture' (what they have experienced) and 'situation' (where they are and where they want to go.)

For these reasons, an investor's time horizon is not a factor that influences a person financial risk tolerance, in the same way that time horizon does not affect a persons present IQ or personality profile. An investor's financial risk tolerance is how they feel about volatility per se.