Risk Tolerance

Risk Tolerance: Knowing Your Limitations and Working Around Them

Winning traders know how to tolerate risk. Trading outcomes are far from definite, but they don't mind. They have no problem putting on trade after trade and doing so with grace and nonchalance. Not everyone can live up to this standard, however. Many novice traders have trouble taking a risk, even a small one. They either avoid executing a trade, or when they do, they find it excruciating to monitor the trade as they wait to see if their profit objective will be reached. Depending on your background and personality, you may have trouble tolerating risk. But don't let it dash your hopes of making profits. You can develop a way to work around a low tolerance for risk.

When you find risk taking particularly fearful, it's hard to concentrate. You are continually on edge and tempted to close out a trade just to end the uneasiness. Part of risk tolerance is biological and part of it is socially learned. Some people are easily agitated and once they become anxious, they find it difficult to calm down. They continue to remain anxious and on edge, even when a threatening event has passed. If you are easily agitated, it's useful to take precautions to reduce your propensity for over-stimulation. The mind and body go together and there are many ways to reduce your overall level of agitation. For example, if you exercise, avoid caffeine, meditate, eat nutritiously and get plenty of rest, you will stay more relaxed. That said, it's hard to fight biology. If you've always been the kind of person who gets anxious easily, you'll have to find a way to work around this aspect of your personality.

If you find taking risks especially difficult and extremely anxiety provoking, you may need to adapt your trading style to fit your physiology. There's no one right way to do this. It depends on your preferences. But one issue to consider is the length of time you stay exposed to risk. The longer a trade, the more risk involved. Scalpers, for example, take minimum risk. They get in and get out of the market as fast as possible. Some anxiety-prone people may find this kind of fast-paced trading especially stressful, but others may find it appealing. You don't have to wait very long to see how a trade turns out.

At the other extreme, long term investing can be another option. Some companies have relatively consistent long-term trends. By doing some simple homework, you can identify a few solid companies and use a buy-and-hold strategy. After you buy the stocks, make a conscious decision to restrict the number of times you look at the price. You might decide to look only a few times a year, for example. Looking at how the stocks are doing can be a lot like looking at a slot machine or roulette wheel. When you look at it, you'll feel anxious as you anticipate what might happen. But if you avoid looking, you'll see the grain of truth in the saying, "out of sight, out of mind." That's not all you need to do, however. You will also find it useful to put a stop loss in place to limit your risk. Defining the amount of risk you are taking up front will help you tolerate risk. (Remember, though, that you must account for volatility over the course of the trade. It's impossible to completely eliminate all risk. You must find a happy medium between getting stopped out too early or allowing your investment to fall in value to an uncomfortable level.)

There's one last thing you can do: Accept the fact that should the market go against you, you will definitely lose the portion of capital that isn't protected by your stop-loss. In the end, you must accept that you may lose. One of the main reasons people have difficulty taking a risk is that they are afraid of the consequences of a potential loss. They wonder what they would tell their spouse or their parents should they lose. They wonder what they would need to do to make back the lost money. It is vital that you trade with money you don't mind losing. If you can truly believe that losing the money is no big deal, you'll be able to tolerate the risk, even if you have extremely low risk tolerance. But if you can't afford to lose the portion of your capital you are risking on the trade, don't risk it. You will never be able to convince yourself that it is a good idea, and if you have low risk tolerance, you will just be putting yourself in agonizing pain.

Extremely low risk tolerance can severely hamper trading, but if you take the proper precautions, you can still trade profitably. By finding a trading style that suits your personality and only risking money you can afford to lose, you'll feel calm enough to trade freely and profitably.