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Risk tolerance refers to the amount of risk an investor is willing to accept in an investment. Investors use their risk tolerance to determine how to allocate their investments within their portfolio. They also use their risk tolerance levels to ensure their portfolios are sufficiently diversified.
Often, in investments, there is an inverse relationship between risk and return on investment. For example, keeping money in a bank account is considered a no-risk investment in most countries because insurers, such as the Federal Deposit Insurance Corporation (FDIC) in the United States, guarantee that the money will be safe within the bank. The money cannot be lost, but it also earns a very low, if any, return on investment. In other words, the bank pays an investor a very small interest rate or even no interest to keep the money in the bank.
As an investment becomes more risky, the rate of return grows. Certificates of deposit and Treasury bills, for example, pay a higher interest rate than bank accounts because there is slightly more risk associated with these investments. They still pay a lower rate of return than stocks or mutual funds, since there is more of a risk of loss when investing in stocks and mutual funds.
Each investor determines what he is willing to invest in on the basis of his risk tolerance. An investor who is risk-averse has a low risk tolerance and thus chooses safer investments. He will earn a far lower interest rate than an investor willing to take on more risk — especially if the other investor enters into highly speculative investments with potential for very high gain — but he will also have a relatively small chance of losing his entire investment.
An investor's risk tolerance typically changes over time. Younger investors can afford to take more risks, as they will typically not need the proceeds from their investments for a longer period of time and because they can afford to wait for a market to turn around. Older investors generally become more risk-averse as they age, shifting the allocation of assets in their portfolio from primarily stocks into bonds and other safer investments, since they may be unable to wait for a market downturn to turn around before they need to begin drawing on their investments. Fixed-income retirees are usually the most risk-averse since they depend entirely on the income from their assets to live and cannot afford to lose their capital in a bad or risky investment.