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Let me tell you a little story about risk tolerance.

When I was 16, I hated following the speed limit. I had a brand-new car with a fair amount of zip. And let me tell you, I liked to zip.

And so I zipped my way into a speeding ticket at 16… and 17… and 19… and 20… and 20… and 20… and 22… and 26.

In other words, I had a high tolerance for risk. I got places fast and had a lot of tickets to show for it. High risk, high reward, baby!

Over time, I gave up zipping and decided to start following the speed limit. Part of it had to do with dating my now-husband, who was a cop at the time. Part of it was probably just aging out of driving fast.

You could say I now have a much lower tolerance for risk. I may get places a little slower, but it's a much steadier ride. And whenever I hear sirens coming up behind me, my heart doesn't leap out of my chest — I'm not speeding, so I don't have to worry.

Do I miss the zip from time to time? Sure. It was a fun way to get places fast.

But at this point in my life, it's not worth the stress of dealing with the consequences. At this point, I'd rather plan ahead so I have time to spare and less stress along the way.

It's the same way with money…

In finance, we frequently apply the idea of risk tolerance to how we invest. I know a lot of people who enjoy the zip they get from making risky trades.

A lot of times, it doesn't work out. I don't even need to share a story because we ALL know a guy who made a wild bet and lost it all. That's the way it goes 99% of the time.

But risk tolerance isn't about whether the risk ultimately results in a gain or a loss; it's about how people handle the risk.

I have a close friend who makes high-risk trades even though he and his wife have a relatively low risk tolerance. At the beginning of 2021, he moved his entire portfolio into dogecoin — yes, dogecoin — and rode it all the way up to a huge six-figure profit before it cratered back down to earth.

His wife didn't sleep well that entire year. And neither did he, because he was up all hours watching the price tick up and down.

One time, at a BBQ I was hosting, he asked me to put the live chart on the TV so he didn't have to keep pulling his phone out to check the price.

Yeah, I'd take "peace of mind" over that "zip" any day.

Decoding Financial Risk (It's Not Just About Investments!)

If you've been trading or investing for a long time, you probably have some familiarity with risk tolerance. In investing, "risk" specifically refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. There's often some kind of tradeoff to make the risk worth it — high risk, high reward. Otherwise, we'd all take the guaranteed three-point shot.

But I think the ideas of risk and risk tolerance apply to all aspects of personal finance, not just investing.

We certainly deal with "risk" in other areas of personal finance. Risk can look like losing your job, receiving an unexpected bill, or even something as minor as rising grocery costs.

It makes sense then that we'd also have levels of risk tolerance. Some people are comfortable living paycheck to paycheck, while others can't sleep well at night without six months of expenses in their bank account.

Just like we see with investing, it's important for your personal finance choices to reflect your risk tolerance. This will help you avoid unnecessary stress — and that's always a plus when it comes to money.

Now, I want to make an important distinction here. Risk tolerance is not the same as risk capacity. Risk tolerance is about how well you emotionally handle the potential for a financial surprise, not whether you can actually afford it. (That's risk capacity.)

The two certainly can be related; a person with a high net worth may also have a high level of risk tolerance because they know they have more than enough money to cover an unexpected expense.

But it's not always the case.

For example, when I was right out of college, as long as I had $50 in my checking account, I didn't worry. Period. (And even when I did dip below that amount, I mainly worried about the call I would get from my mom, who could see my account balance.) Low risk capacity, high risk tolerance.

Today, I'm in a much better spot financially (higher risk capacity) than I was at 22, but I get antsy any time our emergency savings isn't fully funded (lower risk tolerance).

That's because risk capacity isn't the only thing that determines your risk tolerance. There are several other factors that can influence this level, including…

- Age (younger people often have a higher risk tolerance, older people often have a lower tolerance)

- Income and where you are in your career (when people have higher discretionary income, they often have higher risk tolerance)

- Personal experience and attitude (someone who has dealt with financial insecurity may have a much lower risk tolerance regardless of other factors)

- Financial goals and timelines (someone hoping to buy a house in the next three months may have a lower risk tolerance)

Whatever the reason, where you fall in the risk spectrum can — and often should! — play a role in what you do with your money. There are all kinds of strategies to achieve different goals, and there's no point giving yourself an ulcer trying to live outside your comfort level.

In other words, it's about how well you sleep at night knowing that potential financial pitfalls are always lurking.

In a future article, I'll dive into how you can assess your own financial risk tolerance with a simple quiz and insightful questions. This will be your first step toward aligning your financial strategies with your personal comfort level, ensuring that your money moves match your lifestyle.

Stay tuned to discover not just what your risk tolerance is, but how you can start incorporating it into every financial decision you make…