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Risky business
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November 10, 2000: 9:48 a.m. ET
Figuring out your true level of risk tolerance takes time
By Staff Writer Jeanne Sahadi
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NEW YORK (CNNfn) - What would you do if your total portfolio lost 35 percent of its value tomorrow? How about 15 percent? Ten bucks says if you're a novice investor you don't know. That's because it's a little like wondering what you would do if your spouse is unfaithful.
You can surmise all you like and you know it's a risk. But unless it happens -- and depending on the offense (stolen kiss? full-blown affair?) -- it's hard to say. Your response would also depend on circumstances, such as how long you've been married, how well you know your partner, and whether you have kids.
Similarly, when it comes to investing, experience is the best way to learn how much risk you're willing to take, experts say, and your risk tolerance will always be influenced by circumstance, namely your financial needs, goals and means.
But there are some ways to gauge whether an investment or investing strategy is too risky for you before you get burned.
Mettle-testing required
A good first step might be taking the kind of risk-tolerance quizzes financial planners and investment firms offer. But remember that they can only give you an intellectual sense of what you would do if your holdings take an express south.
That's because questionnaires can't factor in a key variable: your emotions.
Financial planners say only after they've worked with clients for awhile do they get a true sense of their risk tolerance in investing.
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 OBJECTIVE FACTORS TO CONSIDER IN ASSESSING YOUR RISK TOLERANCE
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Time horizon
Stability of your family life, health and income
Insurance coverage
Debt
Liquid assets
Your comfort level with an investment
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"Once they go through it, they see what their stomachs can take. It's all in emotions," said David Caruso, a certified financial planner based in the Boston area and co-author of Let's Talk Money.
Take Bruce Kirschner, a 53-year-old federal government employee and value investor who says he has a conservative-to-moderate risk tolerance level. When he started investing in the 1970s, "I was a little wilder," he said, noting that he would short stocks and buy the current rage. Today, he said, when he sees an Amazon or a Yahoo go from zero to 60, "I think 'Gee, that's nice,' but it's really not for me because I don't understand those businesses so well.'"
Think dollars and doomsday
And understanding on many levels what you are getting into goes a long way toward keeping your fears in check during a down market.
Paint a worst-case scenario, experts say. Look at the worst quarter for a stock or mutual fund you're considering and ask yourself if you can handle that kind of drop.
And think dollars, not percents. If you have $100,000 to invest, how would you feel if it became $70,000? "It's real and it's scarier," Caruso said.
That kind of drop might not be a problem if your goals for the money are a long way off, or at the very least are not imminent.
It always comes down to, "Am I going to have enough to live on?" said CFP Bill McVay, vice president of the Investment Management Consultants Association.
Of course, if you need the money in the next few years, you probably should not have it riding on the market, said Peter Di Teresa of Morningstar.
Get disciplined and make friends with risk
But, Di Teresa noted, "people typically sell in a down market because they're afraid of losing more, not because they need it."
The way to protect against that kind of fear is to set out a plan and exercise discipline to see that plan through, Caruso said. He recommends you identify your goals, figure out how much you will need to accomplish them, and then adopt an investment strategy consistent with those goals.
Click here for can't-fail portfolios for the conservative, moderate and aggressive investor.
Since all investment strategies involve some risk, educate yourself about how much risk you need to take to achieve what you want. You may think you want your money in as safe a vehicle as possible, but the more secure the investment the lower the potential reward.
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The biggest risk people may take in life is their job. If I could guarantee your job for life, would you take it? Now what if I said I would pay you half of what you're worth?
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David Caruso, CFP |
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Caruso put it this way: "The biggest risk people may take in life is their job. If I could guarantee your job for life, would you take it? Now what if I said I would pay you half of what you're worth?" That's the difference, he said, between the 12 percent historical return for stock investments and the 6 percent return on bonds over the long term.
Of course, you may not need to take as much risk as you think if your goals are modest or the amount you have to invest is generous, McVay said. Or, if you have to take more risk than you are comfortable with to achieve what you want, you might need to rethink your goals.
Think probability
Many risk-assessment tests will ask you directly how much volatility -- or performance ups and downs -- you can stand. A better question is, "What's my probability for success?" McVay said. Or, if you're a pessimist, "What's my probability for failure?"
A little history is helpful here. For instance, Caruso said, there have only been two five-year periods since World War II when you would have lost money if you invested in the S&P 500 for the full five years. It also pays to read about different down markets -- for instance, the Great Depression and the bear market of 1973, said John Rekenthaler, director of research at Morningstar.
There are also tools available to investment consultants, such as those using the Monte Carlo simulation, that can help you determine a portfolio's probability for success. That may signal to you whether or not such a portfolio is a good fit for you.
"If, by my nature, I'm more risk averse and the probability of failure is 20 percent, that may be too high for me," McVay said.
Signs you're in over your head
But chances are you're reading this long after you sent money to your broker or your 401(k) plan. And your doubts about your investment choices have only grown since you started the article.
Then the most basic question you need to ask, experts say, is, "Can I sleep at night?"
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People become risk tolerant when they become educated about the market.
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John Rekenthaler
Research Director, Morningstar |
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It's a soft question but a key one. If you're having bad money dreams, it may be time to move into a more conservative investment, at least for a while. It doesn't mean you're a weak or bad investor. It just means you have gone outside the bounds of your personal comfort level. And life is too short to be miserable, Rekenthaler said.
But there is a difference between lowering the risk-level of your investment because you've exceeded your comfort level or because you've been seized by panic based on too little information.
"When panic strikes, try to be calm. If that doesn't work, it's OK to panic. Just don't panic for the next 30 years. Learn from the experience," Rekenthaler said. In other words, don't get out of the game entirely. Investing is still one of the better ways to make money over the long term.
One lesson worth remembering? Risk tolerance is something that develops over time.
"People become risk tolerant when they become educated about the market," Rekenthaler said. 
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