How Much Risk Tolerance Can You Handle?

Posted on August 29, 2007

A certain amount of risk tolerance in personal finance is necessary. You would have far less if you invested your retirement fund in a savings account earning four percent interest for thirty years as opposed to a Fortune 500 index fund earning a conservative average of eight percent. We have all seen the graphs depicting the differences in final totals of four percent versus eight percent over thirty years. Investing in the Fortune 500 requires a moderate amount of risk tolerance given the ups and downs of the market. How do you personally determine the amount of risk you can tolerate in your investments? This is some of the processes I use to determine how much risk I am willing to accept in return for a modest return on investment:

When will I need to use the money? The most direct way to know if I should invest aggressively or conservatively is to be aware of when I will need the money. If the money is going into an emergency fund with a possibility of being used in a less than a year then an online savings account (HSBC) earning 5% is the route I go. However, for retirement funds such as my 401K and ROTH IRA I am very comfortable investing aggressively with almost 90% stocks in the portfolio.
What are my goals for the money? Another factor for assessing risk tolerance is to understand what goals I have for the money. Do I need the money to be there no matter what, such as in the case of a future house down payment or is the money used for future savings that could with stand the chance of losing a portion of it.
What is my income? If I am worth $30 million (and I am not), I could invest much more conservatively while achieving a comfortable lifestyle. If I am worth $30 thousand, I will need that money to work for me to provide a better lifestyle in the future, therefore accepting more risk. An example of this is in the Suze Orman NY Times interview where she talks about her personal investments:

“I buy zero-coupon municipal bonds, and all the bonds I buy are triple-A-rated and insured so that even if the city goes under, I get my money. I take a little lower interest rate to make sure my bonds are 100 percent safe and sound.”

As a result of her high net worth and nearing retirement age she can invest conservatively and live a comfortable lifestyle, while she frequently preaches to her audience to invest aggressively early on in your career to build the capital necessary to retire comfortable and debt free. She addresses the negative press the NY Times article earned her in this Yahoo Finance article.
What is my experience and understanding of the investment? If I am investing blindly in an overseas emerging markets fund, even with a high Morningstar rating, I approach with caution. I have taken my chances and invested short term funds in aggressive investments while accepting the fact I could lose money for the opportunity of high returns. Financial markets and vehicles I have no understanding of such as futures, shorting, and commodity trading I stay clear of and leave that to the professionals.
Can I sleep at night with the investment? This is the intangible test after I have answered all of the above questions. Can I be comfortable with the fact I may lose some or all of the money? While I don’t think any wants to lose all their money, the chance to gain double digit percentage increases allows me accepting a high level of risk.