What does 'risk tolerance' mean in the context of investing?

Risk tolerance refers to an individual's willingness to handle fluctuations in the value of investments over time. In the context of investing, understanding one's risk tolerance is crucial, as it shapes investment decisions and helps determine the types of assets in which an investor should engage.

An investor with a high risk tolerance might be comfortable with investments that have the potential for significant price swings, such as stocks or certain mutual funds, believing that the potential for high returns outweighs the anxiety that comes with market volatility. Conversely, an individual with a lower risk tolerance may prefer more stable investments, such as bonds or fixed deposits, to avoid the stress associated with potential losses.

This concept is pivotal because it guides how an investor can construct a portfolio that aligns with their financial goals and emotional comfort in handling market risks. Understanding risk tolerance can lead to more informed investment strategies and greater satisfaction with one's financial planning.