How does risk tolerance influence investment decisions?

Risk tolerance is a critical factor in shaping an investor's decisions regarding which assets to include in their portfolio. It is defined as the level of variability in investment returns that an individual is willing to withstand in their investment strategy. By understanding their risk tolerance, investors can identify which types of assets align with their financial goals and emotional comfort levels.

For example, an investor with a high risk tolerance might choose to invest in stocks, which can offer higher potential returns but come with greater volatility. In contrast, an investor with a low risk tolerance may prefer more stable assets like bonds or mutual funds that provide steadier, albeit lower, returns. In this way, risk tolerance directly informs the asset selection process, ensuring that individuals engage with investments that suit both their financial objectives and their psychological capacity to handle market fluctuations.