What is Your Investment Risk Tolerance?

Mention the word “risk” in the context of a discussion about investing, and what springs to most people’s minds? A huge loss when the stock market takes a dive? Or when the price of bonds tumbles?

Most likely. Such possibilities lead some people to cling to the “safety” of passbook accounts or certificates of deposit, failing to recognize that risks are inherent in this kind of savings, too.

Inflation risk

We all think we know what inflation is. It’s going to the store and buying the same loaf of bread that you did a few weeks ago, and finding that it costs more. It’s discovering that your kids’ college education will cost ten times what yours did. It’s realizing that what you have to spend buys less than you think it will.

A sneaky thing about inflation is that you’re usually comparing these “inflated” purchases in short time periods—weeks or months. It’s when you look at years of inflation that you begin to understand fully how damaging it can be to what you’ve earned and saved over the years.

A return on your investments that doesn’t at least match inflation means that you’re not saving, you’re losing. Only if your investment return surpasses inflation can you expect to be truly gaining ground.

Market risks

The history of the financial markets suggests that investments in stocks are most likely to beat inflation over time. That’s one reason that so much new investment has been pouring into equity mutual funds in recent years.

Yet, if there is one thing that the market reverses of the recent past have taught us, it is this: Investors can’t take stocks for granted.

Interest-rate risks

Bonds, especially longer-term bonds, generally offer investors a yield that is superior to short-term investments such as savings accounts. The return from a bond portfolio or bond mutual fund is generally more predictable than stock returns. However, if interest rates should rise, the value of the bonds will fall, which can lead to a loss of principal.

Managing risk

Just because an investment bears risk doesn’t mean that you need to spend sleepless nights worrying about your financial future. Rather, you need to manage risk in a manner that brings you peace of mind.

The first step in that process is determining how much risk you can live with—and stick with. Then look at what you can do to reduce your risk. Consider these factors:

Age. The younger you are, the more risk you should be willing to take. Time is your ally. Because, over the long term, stocks have consistently outperformed any other kind of investment, younger investors can afford more exposure to stocks. They have more time to make up for short-term setbacks.

Other investments. Look at your current mix before deciding what to do next. Having too much money in any one kind of investment can be dangerous. Diversifying your investments—creating a mix of stocks, bonds and cash investments—reduces risk.

Knowledge. Do you follow the markets? Do you read The Wall Street Journal regularly? Or do you find the subject of investing confusing or boring? Obviously, the more that you understand, the more confident you are going to feel about investing. With confidence comes a higher comfort level for taking risks. It also increases the likelihood that you’ll make the right choices.

Attitude. Some people might say that they are satisfied if their investments just keep pace with inflation. Others would gladly accept significant risk for the chance to reap big returns. Where do you fall within the spectrum?

Once you understand your tolerance for risk and the ways to reduce risk, you’ll want to evaluate your investment choices. You should do so by carefully balancing each investment’s potential risk and reward.

Study your choices and make a decision on your own, or consult someone you trust for advice. Don’t act hastily or follow the pack just because you don’t know what to do.

Remember the tortoise and the hare

The general rule about extremes applies to investing: Avoid taking too aggressive or too conservative an approach.

For most people a slow-but-steady pace with regard to investing is best, both in terms of a sense of security and potential financial reward.