Risk Tolerance

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Risk tolerance is a psychological trait, i.e. a distinguishable, relatively enduring way (see stability of risk tolerance) one individual differs from another, and as such is amenable to psychometric testing (see psychometrics.)

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.

Relationships with demographic factors have been extensively studied and some patterns are emerging - see demographic correlations of risk tolerance.

Other risk-related constructs include Risk Capacity, Risk Required and Risk Perceived. See Balancing Risk about how to deal with all four risk constructs.