Investing

Investing 101: Defining Your Risk Tolerance

photo: oedipusphinx — — — — theJWDban

Every investor needs to determine what kinds of investment strategies are appropriate given their risk tolerance level. This means the level of risk and uncertainty that you can afford to take, and are willing to take.

This is not a matter that is set in stone. Your risk tolerance is likely to change with your age, income, knowledge, marital status, and other important life events, such as buying a home, a child’s college costs, or retiring.

Anyone who tells you what investments to buy without knowing anything about you is giving you poor advice. A responsible way to decide what investments and strategies are best, is to start by deciding whether you’re willing to take big risks for the chance at big profits, or would prefer a safe and sure approach for lower potential reward.

An aggressive investor or speculator is willing to use high-risk strategies in the quest for fast, exceptionally high profits. However, this approach also means to risk losing a lot of money. High profits and high losses are two of the possible outcomes to aggressive investing strategies.

A moderate investor believes in balancing a portfolio through asset allocation and diversification, spreading risks among many different products and strategies. It is also likely that moderate investors will diversify by risk level, including some relatively low-risk choices along with a few relative higher-risk ones. A moderate hopes to either match the market and keep up with inflation, or to gain a slight edge. However, a moderate is also a realist, and does not buy the “get rich quick” argument speculators are drawn to.

A conservative investor is willing to accept lower returns for the safety of their capital. So they are likely to pursue insured returns from money market accounts, or guaranteed returns from annuities. However, these returns are going to be quite low. An evaluation of the after-tax, after-inflation return might reveal that ultra-conservative returns lose money. To calculate the return, divide the current rate of inflation by the after-tax income you earn.

For example, if your effective federal and state combined tax rate is 40% (0.4) , then your after-tax income is 60% (0.6) of your total income. Assuming a 3% inflation rate, the breakeven calculation in this example is:

3   ÷   ( 1 – .4 )  =  5%

This calculation tells you that if inflation is 3% and your tax rate is 40%, you have to earn a return of 5% just to break even. If you earn less than 5%, you are losing money after inflation and taxes. This is sobering. It means that being overly conservative is itself a type of invisible risk.

Deciding your risk tolerance is a balancing act. Most people do not want to take risks that are simply too high; and being too conservative erodes the value of your capital. Somewhere in the middle — probably in the range of “moderate” — is where most people find their most suitable risk tolerance level.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.

Investing 101: Hidden Fees in No-Load Funds was provided by Minyanville.com.