How to assess risk tolerance

By Mary Rowland

When you're ready to invest, the first question you're likely to hear is: How much risk can you handle? That's because a person's tolerance for risk is inextricably intertwined with a person's willingness to invest.

For those with little investing experience, risk usually means this: What is the possibility that I will lose some of my money? Will my $1,000 ever be less than $1,000? If it might, that's too much risk. End of discussion. The truth is, though, that most of us need to invest. The less we have, the more we need to earn a good return. Only the rich can afford to use guaranteed investments. The rest of us must learn how to stretch our risk tolerance if we are to achieve our financial goals.

You've probably heard that "risk and reward go hand in hand." It's not quite that simple. If you knew you'd get a reward, you'd take the risk. But when you take on more risk, your reward might be a loss. So you need to learn a little more about this hand-holding.

Investments stretch along a risk-reward continuum, from those that produce a steady, predictable income to those that offer the chance, but not the promise, of growth. At the low-risk end is a bank passbook account, a conservative, guaranteed-income investment. If you take $1,000 and put it in the bank, you are guaranteed that you will get your $1,000 back. And you are guaranteed an income at the passbook rate, which currently is about 3%. You would earn $30 in a year.

What if you use your $1,000 instead for a down payment on a $10,000 piece of property? There are no guarantees here. You may never see the $1,000 again. But say you clear the land to expose a view of the ocean and sell it for $50,000. It required some vision, and a big risk, on your part. But the $1,000 you invested in real estate is now worth $41,000! (After you pay the debt, of course.)

Types of risk

Most investments lie somewhere between these two extremes on the risk spectrum and the risks are more subtle. One of the biggest financial risks is inflation risk, or the risk that our money will not be worth as much in the future. Guaranteed investments like bank accounts don't keep pace with inflation. Opportunity risk is the chance you take when you tie your money up in a so-so investment like a bank certificate of deposit and lose the chance to put it into something with real growth potential.

You take on concentration risk if you put all your money in one stock, or in your home or your business. All investors are affected by interest-rate risk or the chance that interest rates will change the value of their investment. But interest rates have the greatest effect on bonds. When rates rise, the value of bonds fall. And the longer the term of the bond, the more it falls. So an increase in interest rates will have a much greater impact on a 30-year bond than on a five-year bond.

Credit risk is the chance that a borrower won't repay what is owed. Bondholders face this risk, too. So do investors in money market funds, which are short-term loans in the money markets. But the risk is much greater for bondholders because the term of the debt is longer. Marketability risk is the chance that there will be no ready market for your investment if you want to sell it in a hurry. That's certainly a big risk if you buy a piece of land, or if you buy a stock that is very thinly traded. But it's not a risk when you buy a mutual fund, which you can sell back on any business day.

Gauging your risk tolerance

Many novice investors see the stock market as risky because it can be volatile, which means it moves quickly and unpredictably. Yet it is not the behavior of the market, but the behavior of the investor that is the most important issue with stocks. Many investors behave irrationally, jumping in when the market goes up and selling when it sinks. If you stayed in the market during the rough times, you went a long way toward solving the issue of risk tolerance.

When Richard Thaler, a University of Chicago economist, spoke to a group of financial planners in Palm Beach, Fla., this winter, he told them that Rip Van Winkle would be the ideal stock market investor. Rip could invest in the market before his nap and when he woke up 20 years later, he'd be happy. He would have been asleep through all the ups and downs in between. But few investors resemble Mr. Van Winkle. The more often an investor counts his money -- or looks at the value of his mutual funds in the newspaper -- the lower his risk tolerance, Thaler said.

The two most critical factors in dealing with risk are your time horizon and your discipline. If you have the time -- 10 years is best -- to let your money grow and the discipline to leave it alone, the stock market provides the best returns.

Mary Rowland has been writing about personal finance and investing for 25 years. She was the Sunday New York Times personal finance columnist from 1989 to 1995. Her articles have been featured in Fortune, Worth, Business Week, Bloomberg Personal, Money, Woman's Day, Family Circle, McCall's, Ladies' Home Journal and USA Today. She is the author of several books on personal finance, the most recent being "The New Commonsense Guide to Mutual Funds." She also speaks frequently to both investors and financial planners. She lives in New York's Hudson Valley.