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How to Gauge Your Risk Tolerance and Why It's Important

Barbara Marquand | guest writer for GoTalkMoney

Risk varies widely among investments--from dependable and safe money market accounts and certificates of deposit to speculative futures and options trading--and the ability to handle risk varies just as widely among investors.

Just how much money are you willing and able to lose if an investment goes sour? The answer is your risk tolerance, and it's an important factor to determine as you craft your financial strategy.

Its also an issue gaining attention in the wake of a turbulent market and economy. Three-quarters of financial advisers polled in November 2009 by Brinker Capital, an investment management firm, reported a disjunction between clients' perceived and actual levels risk aversion. Many people who thought they could tolerate risk in the stock market cracked once the economy and market tanked.

Determining your risk tolerance is tricky because it combines your financial capacity for risk with your comfort level for risk, and both of those can change over time. Here are four questions to get you started thinking about risk tolerance.

1. Your Investments: When Do you Need the Money?

As a general rule of thumb, your risk tolerance is lower if your time frame is shorter, say five years instead of 20 or 30 years. That's why financial experts advise parents to move at least some of the money they're saving for their children's college educations out of the stock market and into other vehicles, such as certificates of deposit, once their kids become teen-agers. If you're investing for the long term, you can be more aggressive. However, that doesn't mean just because you're nearing retirement that you have to move all your money to money market accounts and CDs. With a rapidly growing number of people living into their 80s and 90s, you very well could be investing for a 20-year or longer time frame.

2. What Are Your Investment Goals?

What are you investing the money for, and what do you hope to accomplish with the investment? Remember to keep your goals realistic and in line with one another. You can't realistically expect a 12% annual return without bearing any risk. Higher returns mean increased risk. The safer the investment, the lower the payoff. If you don't have the stomach for the risks you need to take on to accomplish your goals, then it's time to re-evaluate your goals, boost your savings, or step out of your comfort zone (as long as you have the financial capacity to do so).

3. How Much Are you Worth?

If you've got high net worth--total assets minus liabilities--and a pile of money you can invest without sacrificing your lifestyle, then you can stand to lose more than someone who's living paycheck to paycheck. Don't be tempted by risky investments, such as futures, if you have little or no net worth. Sure, those high-risk moves can pay big rewards, but you can also lose everything, and with little or no net assets, you can't afford to lose. Plus, when too much is at stake, you're not likely to make the best decisions.

4. What's Your Investment Personality?

Personality is a factor in investing. Some people love the thrill of the high wire, while others prefer to walk through life comfortably on solid ground. These traits impact how you invest your money. Investments shouldn't keep you up night after night. If you can't stand to take risks, then your investment approach should trend toward more conservative choices. A good financial advisor can talk to you about your risk tolerance and may have you fill out a risk tolerance questionnaire.

Two university personal finance professors, Dr. Ruth Lytton at Virginia Tech and Dr. John Grable at Kansas State University, developed an investment risk tolerance quiz. Questions range from personality queries, such as how your best friend would describe you as a risk taker (possible answers include "a real gambler, willing to take risks after completing adequate research, cautious, or a real risk avoider") to how comfortable you are investing in stocks and stock mutual funds. The professors are among experts researching how to develop better instruments for testing risk tolerance.

Of course a quiz can't tell you what investments to make, but it may provide some good food for thought as you think about your financial moves going forward.


Source:

George Mannes • How much risk can you stand? • money.cnn.com • http://money.cnn.com/2009/10/07/pf/risk_tolerance.moneymag/index.htm
Paul Sullivan • Here's $50 Million; What's Your Risk Tolerance? • The New York Times • http://www.nytimes.com/2009/07/10/your-money/asset-allocation/10wealth.html
Michaela Cavallaro • VOICES: Cathy Pareto, On Managing Risk • • http://blogs.wsj.com/http://blogs.wsj.com/financial-adviser/2010/01/06/voices-cathy-pareto-on-managing-risk/
Securities and Exchange Commission • Determine Your Risk Tolerance •  http://investor.gov/determine-your-risk-tolerance/
Mary Rowland • How to assess risk tolerance • MoneyCentral • http://articles.moneycentral.msn.com/Investing/SimpleStrategies/HowToAssessRiskTolerance.aspx
Investopedia • What is the difference between risk tolerance and risk capacity? • http://www.investopedia.com/ask/answers/08/difference-between-risk-tolerance-and-risk-capacity.asp

Disclaimer:This content is not provided or commissioned by American Express. Opinions expressed here are author's alone, not those of American Express, and have not been reviewed, approved or otherwise endorsed by American Express. This site may be compensated through American Express Affiliate Program.

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