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The degree of variability in investment returns that an individual is willing and able to withstand in pursuit of their financial goals.
Risk tolerance has two dimensions: risk capacity (the financial ability to absorb losses based on time horizon, income, and wealth) and risk willingness (the emotional comfort with volatility). A 25-year-old with decades until retirement has high risk capacity, while a retiree living off a portfolio has low risk capacity. Risk tolerance directly influences asset allocation: aggressive investors might hold 90% stocks, while conservative investors might hold 30% stocks and 70% bonds. Importantly, many investors overestimate their risk tolerance during bull markets and only discover their true tolerance during a significant downturn.