Basically, risk tolerance is the measure of how much risk someone can handle as an investor.
Financial advisors say that risk tolerance is the amount of risk that an investor is comfortable taking, or the degree of uncertainty that an investor is able to handle, explains Manisha Thakor, director of Wealth Strategies for Women at Buckingham and The BAM Alliance.
Risk tolerance often varies with age, income and financial goals. It can be ascertained by many methods, including questionnaires designed to reveal the level at which an individual can invest but still be able to sleep at night, Thakor said.
When it comes to risk tolerance, investors need to ask themselves some tough questions, according to Thakor. For instance: How much money do you have available? And how much of it can you afford to lose?
Thakor said investors also need to look at their financial time frame. The length of time remaining until you reach your goal matters when it comes to how much risk you can handle in your portfolio. For example, as investors approach retirement, they will have a lower risk tolerance, since they don't have decades to rebuild if a riskier investment causes problems.
Additionally, emotions come into play when you are talking risk tolerance, she said. If risky investments are going to stress you out to the point that it affects you in other areas of your life, that can be an issue. It also matters if you are so risk-averse that you never include investments that can potentially grow your wealth.
As an investor, it's very important to take the time to get a handle on how much risk you can accept as you approach the market from a long-term view, Thakor explains, adding that you need to determine your financial goals before you begin investing.
Consider what you want to accomplish with your money and how your investment portfolio fits into the overall financial plan, Thakor says.
—By Jim Pavia, senior editor at large