Risk Management, Trading Education

What is the Relationship Between Risk Tolerance and Success in Trading?

Risk reward - day trading 101

Risk tolerance plays an important role in the decision making process of every trader, however, the question of whether it directly correlates to trading success is complex.

Furthermore, if it does correlate to success, is a higher or lower risk tolerance better? The argument for a higher risk tolerance is that capturing large profits requires a willingness to go against the market and therefore tolerating trades which go against you. Conversely, the argument for a lower risk tolerance is that it prevents a traders ego from riding bad positions further into the red. The reality is that there is not a hard and fast answer to this question. Instead, the relationship between trading success and risk tolerance is determined on an individual basis. To try and disassemble the truth about risk tolerance and trading as it relates to each individual trader, three critical factors are outlined below:

Psychology and Risk Tolerance

Ultimately, good trading comes from a mechanical and unbiased ability to evaluate markets and individual securities. Unlike artistic functions and even some business functions (advertising for example), the world of trading will always reward a higher degree of objectivity.

This means that psychological bias towards OR against risk-taking is a disadvantage. Rather, the ideal mental state of a trader should be indifference to their own emotions. Of course, this can never be achieved to an absolute degree, however, careful model construction and habitual self-evaluation will help traders recognize their own tendencies and fight them. This concept can be visualized as a linear spectrum (shown below) of risk preference; the goal of every trader is to land in the middle of the spectrum.

Traders should examine their psychology with respect to risk tolerance and identify areas of weakness before they result in large losses. That is, if you have a tendency to be too aggressive then you should construct your strategies to mitigate that tendency and vice versa if you tend to be too timid.

What is Your Goal?

Given that the aforementioned risk tolerance bias can never be totally removed, aligning goals with a traders psychology is another way to dampen the negative consequences of that bias. That is, is the trader trying to generate the largest absolute return possible or does he/she prioritize consistency of returns over the absolute result? Generating large returns will be less punished by  a greater degree of risk tolerance while generating consistent returns will require a willingness to exit positions rapidly and thus be less punished by a lower degree of risk tolerance.

Structure Matters Most

The aforementioned need to design strategies around your psychology highlights the importance of structure. A lack of structure frequently undermines a traders ability to work with his/her own psychology. Without a clear plan which defines specific actions in response to every scenario, traders will be subject to the clouded judgement of their own emotional biases. The obvious lesson here is to recognize your risk tolerance and create precise structures which prevent your risk tolerance from causing you to overextend or underextend a trade. For example, traders who have exceptionally high risk tolerance can set stop losses more aggressively while traders with very low risk tolerances can set stop losses lower than their instincts dictate.

How Does Risk Tolerance Affect Trading Success? 

It seems that although a higher or lower risk tolerance does not directly affect a traders potential to succeed, the ability to internally recognize risk tolerance and align it with one’s goals and trading structure does play a significant role in becoming a successful trader. To improve your trading, review the three factors above and implement changes which make your degree of risk tolerance work for you instead of against you.

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