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Beginner's Guide to Risk Tolerance

TheStreet.com Ratings Staff

01/10/08 - 04:25 PM EST
Editor's note: This is a special excerpt from TheStreet.com Ratings' Ultimate Guided Tour of Stock Investing. Other Beginner's Guides cover stock basics, market indices, diversification and financial goals.

Taming That Animal Called Risk

Once you stare risk risk in the face, we promise you won't be scared. To get a grip on risk before it gets a grip on you, ask yourself these four important questions:

1. How Much Risk Can I Handle?

Only as much as you're comfortable losing.

Take on too much risk, and you'll panic, selling at the worst possible time. When's that? When you sell low, which is the opposite of tried-and-true investing smarts -- buying low and selling high.

Ask yourself: How much am I comfortable losing capital-loss over a year and still be able to stick to my plan (see "Beginner's Guide to Financial Goals")?

5% or less? You have a low tolerance for risk risk-tolerance.

6%-15%? You have a moderate tolerance for risk.

16%-25%? You have a high tolerance for risk.

Let's assume you have $10,000 to invest (see capital capital).

If you are comfortable losing only $500, then you have a low tolerance for risk.

If you could handle losing up to $1,500, you have a moderate tolerance for risk.

You have a high tolerance for risk if you could accept losing up to $2,500.

2. How Do I Balance Risk Against My Expectations?

Don't take on more than you can handle. There's always a tradeoff with risk -- the greater the uncertainty, the greater the potential for higher returns return. Stay in your own personal risk zone, regardless of what the market does (see "Beginner's Guide to Market Indices").

3. How Can I Reduce My Risk?

In real estate, it's location, location, location. In stock investing, it's diversify, diversify, diversify (see "Beginner's Guide to Diversification"). To reduce your risk, it's smart to invest in all the major asset categories asset-class (stocks stock, bonds bond and cash liquid-asset), which are affected by different economic and market factors.

You can also spread your risk by diversifying further in each asset category. In the stock category, for example, you diversify by choosing stocks in several different industries (see "Industries vs. Sectors: What's the Difference?"). If you choose just one stock, you can wipe out your entire portfolio if that one stock decreases in value market-value. Choose several in various industries, so that when one goes down, others will stay put, or go up, and balance out your total performance.

4. How Can Risk Reward Me?

With more money! Historically, the stock market has earned more returns for investors than bonds or cash. And over time, that difference adds up to a lot of money.

Now you're ready to take our Investor Profile Quiz, which will help you figure out the risk you want to take.

What's Your Investing Speed: Slow and Steady or Smokin'?

Each person approaches his or her investment decisions from a unique perspective: theirs! A stock investment that's perfect for someone else may be totally wrong for you, depending on several factors:

Investing is all about risk risk and return return; you can't get a handle on one (return) without knowing more about the other (risk).

How fast do you want to go as you head down the trail? Slow (conservative), steady (moderate), or fast (aggressive)? The following quiz can help you understand your investing speed. The number at the end of this quiz will tell you how much risk you're willing to take for the returns you need to earn to reach your goals.

The challenge is turning numbers into action, of course. Expectations, colored by our emotions, often get in the way.

As you read through each question, circle the one answer you feel most accurately describes your current point of view. There are no "correct" answers to this quiz, only answers that help you figure out the investment speed that fits your style. Don't worry about how others might view your answers -- this is for your eyes only! But it's important to be as honest and accurate as possible.

Ready to get a handle on the risk and return that's right for you? Let's go to the quiz.

Beginner Investor Quiz
1. I expect I will need to liquidate some or all of my investments in: Points Your Score
a. 2 years or less 0
b. 2 to 5 years 5
c. 5 to 10 years 8
d. 10 years or more 10
2. My age group is:
a. Under 30 10
b. 30 to 44 9
c. 45 to 60 7
d. 61 to 74 5
e. 75 and older 1
3. I have a cash reserve equal to three to six months of expenses.
a. Yes 10
b. No 1
4. My primary source of income is:
a. Salary/other earnings from my primary occupation. 7
b. Earnings from my investment portfolio. 5
c. Retirement pension and/or Social Security. 3
5. I will need regular income from this investment now or in the near future.
a. Yes 6
b. No 10
6. Over the long run, I expect this investment to average returns of:
a. 8% annually or less 0
b. 8% to 12% annually 6
c. 12% to 15% annually 8
d. 15% to 20% annually 10
e. Over 20% annually 18
7. The worst loss I would be comfortable accepting on my investment is:
a. Less than 5%. Stability of principal is very important to me. 1
b. 5% to 10%. Modest periodic declines are acceptable. 3
c. 10% to 15%. I understand that there may be losses in the short run, but over the long term, higher risk investments will offer highest returns. 8
d. Over 15%. You don't get high returns without taking risk. I'm looking for maximum capital gains and understand that my investment can substantially decline. 15
8. If the stock market were to suddenly decline by 15%, which of the following would most likely be your reaction?
a. I should have left the market long ago, at the first sign of trouble. 3
b. I should have substantially exited the stock market by now to limit my exposure. 5 pts 5
c. I'm still in the stock market, but I've got my finger on the trigger. 7
d. I'm staying fully invested so I'll be ready for the next bull market. 10
9. The best way to protect my investment when stock prices are falling is:
a. To time my purchases and sales of stocks to avoid large losses. 4
b. To invest in stocks now to take advantage when prices start to rise. 10
10. The best strategy to employ when stock prices are falling is:
a. Liquidate stocks and hold cash instead. 10
b. Use more sophisticated trading techniques to make a profit as prices decline. 7
c. Wait it out, because the market will eventually recover. 5
11. I would classify myself as:
a. A buy-and-hold investor who rides out all the peaks and valleys. 10
b. A market-timer who wants to capture the major bull markets. 7
c. A market-timer who wants to avoid the major bear markets. 5
12. My attitude regarding trading activity is:
a. Active trading is costly and unproductive. 0
b. I don't mind frequent trades as long as I'm making money. 2
c. Occasional trading is OK, but too much activity is not good. 1
13. If the S&P 500 advanced strongly over the last 12 months, my investment should have:
a. Grown even more than the market. 10
b. Approximated the performance of the broad market. 5
c. Focused on reducing the risk of loss in a bear market, even if it meant giving up some upside potential in the bull market. 2
14. I have experience with the following types of investments. Extensive Some None
a. U.S. stocks or stock mutual funds 2 1 0
b. International stock funds 2 1 0
c. Bonds or bond funds 1 0 0
d. Futures and/or options 5 3 0
e. Managed futures or funds 3 1 0
f. Real estate 2 1 0
g. Private hedge funds 3 1 0
h. Privately managed accounts 2 1 0
15. Excluding my primary residence, this investment represents ___%
of my investment holdings.
a. Less than 5% 10
b. 5% to 10% 7
c. 10% to 20% 5
d. 20% to 30% 3
e. 30% or more 1
TOTAL

Add the points in the "Your Score" column to get your total. This score will tell you what risk category you currently fall into. Find the category below that matches your total score. Each category gives a description of the types of investments suitable for your risk tolerance.

Under 58 pts. -- Very Conservative

You are not willing to accept the risk involved in aiming for a very high return. You don't want to take much risk at all -- your primary goal is to keep as much of your money as possible. As a result, most stocks may be a little too risky for your taste, especially in a turbulent market environment. We [TheStreet.com Ratings] recommend you stick to the safest bond funds bond-fund and money market mutual funds money-market-fund, where your income stream is predictable and more secure.

To learn more about these types of investments, check out the Booyah Breakdown "Bonding With Bonds" Series and "Mutual Funds: Money Markets." You can also visit TheStreet.com Ratings Screener: Funds and BankingMyWay.com's Money Market Section.

78 to 108 pts. -- Moderate

You're prepared to take on a little added risk to increase your investment returns. This is probably the most common investing approach, with total return (dividends dividend plus stock price appreciation appreciation) as the goal. To select a stock investment matching your style, we recommend that you research stocks with good growth in revenues revenue and earnings earnings that also offer a dividend yield dividend-yield above that of most major indices -index.

You can search TheStreet.com for stories that focus on "dividend stocks."

109 to 129 pts. -- Aggressive

You appear to be ready to ride out almost any financial storm on your way toward maximizing your investment returns. You understand that to make large returns on your investments, taking on added risk in the form of exposure to higher growth and lower capitalization stocks is a typical route to this end. Also, your answers to the risk assessment quiz indicate that your personal situation should allow for that approach. See TheStreet.com Ratings Screener: Stocks, for a selection of buy-rated mid-cap stocks mid-capitalization-mid-cap-stockwith strong growth in both revenues and earnings per share earnings-per-share-eps. (On the stocks screener, select "Recommendation: Buy" and "Market Capitalization: Mid Cap.")

Over 129 pts. -- Very Aggressive

According to your responses, you appear to have little aversion to speculation speculator. Your primary concern is maximizing your investment growth, and you seem prepared to take on as much risk as necessary in order to do so. These investments can be extremely volatile volatility and susceptible to any one of a number of factors. But, they are highly speculative investments that could provide superior results -- if you can stomach the volatility and uncertainty. Research stocks of companies that have market caps market-capitalization between $1 billion and $10 billion and have strong recent and projected growth.

You can search TheStreet.com for stories that focus on "small-cap" and "mid-cap" stocks.

Remember Kathleen?

Because she is funding two goals, Kathleen (see "Beginner's Guide to Financial Goals") takes the test twice. She's willing to take some risk for herself, which makes her a moderate investor, but little, or none at all, to save for her children's educations, which also makes her a conservative investor.

Later, you'll find out how choosing different levels of risk influences the returns you need to reach your goals.

You need to keep your risk scores in mind whenever you think about buying a stock. It will be your best tool in choosing the stock investments that are right for you. Knowing your risk tolerance is critical. You can't do a good job in deciding on your portfolio's asset allocation asset-allocation without it.

Next: The Basics of Growth and Income Stocks.