Risk Aversion vs. Risk Tolerance in Trading

by FX EA Review
Risk Aversion vs. Risk Tolerance in Trading

Risk tolerance

Risk tolerance estimates the level of risk an investor or trader is ready to accept in their trade or portfolio in the financial markets. No matter how much money you have to lose, you should only trade with what you’re comfortable losing.

Investors can fit into one of three groups based on their tolerance for risk. 

Aggressive investors often watch the market movers and factors such as seasonality, making them less afraid of taking big risks. They like to see significant swings in their portfolio’s value, like volatile currency pairs.

However, the time component is critical. Once an investor commits their money to an asset, there is no way to know whether or not they will get their money back. As a result of their high level of risk, they reap more significant gains when the market is on the upswing and suffer massive losses when the market is downturns.

In comparison to their aggressive counterparts, moderate-risk investors have a lower tolerance for risk. They accept some risk and determine a proportion of losses they can absorb. They maintain a healthy ratio of risky and safe assets in their portfolios. For example, in FX markets, that would be in the form of holding safe-haven currencies (USD, JPY, CHF) and a couple of exotic pairs. When the market is doing well, they will make less money than aggressive investors, but they will not lose as much money as they would if the market were to plummet.

Conservative investors are the ones who take the lowest risk in the market. They avoid risky investments at all costs and stick to the ones they believe are the most secure. They place a higher value on averting losses than on gaining profits. In the currency market, for example, they can use forward contracts to cover their current positions. They only invest in a small number of different types of financial instruments.

Risk aversion

A risk-averse investor is one who prefers low-risk investments over those that are more volatile in terms of price movement. An investor with a low tolerance is more likely to focus on the safety of their principal rather than the returns from the assets they invest in. This type of investor is more concerned with managing and fine-tuning their amount of risk than traders who are more risk-tolerant.

Investors who are risk-averse prefer a low-risk investment strategy rather than one that is more geared toward rapid growth. In other words, this investor always chooses the option with the lowest interest rate when it comes to investments that offer the same return with the same amount of risk.

Factors to consider when taking the risk

  • Time: Time is an important factor in investment decision-making. The more urgent your financial needs, the lower your risk tolerance ought to be. Identifying your financial objectives will assist you in determining how much time you have to build your wealth and, thus, how much risk you are willing to take on with the investments you pick.
  • Financial strength: The concept is risk tolerance and financial security-related. If you have a steady salary, low-interest debt, and a budget for discretionary expenditure, you may be more willing to take on greater risk. If you don’t have to rely on your investments to meet all of your monthly costs, you may be less anxious if they go down in value.
  • Investment strategy: Conservative investors prefer to focus on low-volatility assets while building their portfolios. Generally, you should only put your money towards investments you are comfortable with. You should also evaluate your ability and willingness to cope with substantial fluctuations. Taking up too much risk can cause you to lose control and make a hasty exit.

Trading styles and risk tolerance

Some trading strategies suit risk-tolerant investors, better while others do risk-averse investors. Below is a discussion on the trading styles you should consider depending on your risk-taking abilities.

  • Scalping: This is a short-term trading style in which traders or investors try to profit from small price movements on trades that must close within a day. Scalpers seek to make a tiny profit on each transaction by keeping their positions open for only a few seconds at a time. Because of the high frequency of trades, scalping fits experienced traders who are willing to take a risk.
  • Position trading: Holding transactions for months or years is a hallmark of position trading and investing. As a position trader, you must be able to sustain higher price swings over the holding time. In between, you will get opportunities to profit from the swings, as well as from market inefficiencies. 

For instance, you may take a position based on your market assessment and belief that the Federal Reserve will raise interest rates eight months from now, while the Bank of Japan will lower its rates at that time. Therefore, you will buy the USDJPY pair now, even if the dollar is underperforming, and sell it after eight months when the Fed raises interest rates. This will earn you a profit because the dollar may appreciate. This type of approach to investment can suit risk-averse investors.

  • Swing trading: This is a style of trading in which investors keep their positions open for several days or weeks to leverage periodic price swings. The swings may be in the form of corrections or any other significant impulsive price movements. For example, a trader may go long on USDJPY during swing lows and close their position days later when the pair resumes an uptrend.

Both risk-averse and risk-tolerant traders can benefit from this trading approach, which has appealing reward-to-risk ratios and more precise entry positions that lower overall risk.

In summary

The risk of both loss and gain is inherent in every investment decision we make. Therefore, you should determine your tolerance for risk before deciding on an investment plan. 

Some investors will not invest if the risk is more significant than a predetermined level, even when it means missing out on the potentially more substantial returns.

Investing without taking into account one’s risk tolerance can be disastrous. When the value of an investment drops, an investor must know what to do. As a result, determining your risk tolerance can help you avoid making hurried, costly decisions.

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