Editor's note: This is the fourth of five columns in which Vern Hayden discusses current mutual fund investment strategies. In the first three installments, he looked at funds with multiple star managers, funds of funds and asset allocation. Today he examines risk. Still to come: timing strategies.

There are many ways to define risk.

A bungee jumper might define risk as the possibility the cord will break. A basketball coach might define risk as a three-point shot in the final second when his team is down by two points.

In the stock market, risk means the possibility of losing money. For those who aren't in the stock market when it goes up, the risk is the loss of the opportunity to make money. So what's a person to do?

Last week, I discussed the importance of asset allocation in putting together a portfolio of mutual funds. Here's an example:

My best return so far this year is from

(JAOLX)

Janus Olympus, managed by Claire Young. It is up 14%. But I also have Bill Gross'

(HABDX) - Get Report

Harbor Bond, which has a total return of 0.4% this year, and Jim Gipson's

(CFIMX) - Get Report

Clipper fund, which is down 2%. Why would anyone have Olympus, Clipper, Harbor Bond and others in the same portfolio? The answer is obvious: If Olympus tumbles, Harbor Bond is there to help break the fall. Since I do not know when the market is going to correct or become a bear market, I have to keep Harbor around to help control the risk.

That was the basis of last week's column on asset allocation. By using different asset classes, investing has historically been safer. Before discussing timing next week, I thought it important to spend a little extra time on risk this week. (This was originally a four-part series, but with this extra column, I'm extending it to five.)

Few people understand risk until they experience loss. If you have suffered through corrections in the market, you know the difference between an intellectual understanding of loss and the emotional experience of losing. Hopefully, you just experience a paper loss on your reports and do not actually realize a loss by cashing in at the bottom.

The following chart, constructed from three separate charts in

Harold Evensky's

book

Y2K and Your Money

, illustrates the tradeoff between risk and return. Perhaps the most important column is the one showing the worst one-year loss over the 50-year period. Try to imagine that loss over a full 12 months in your own portfolio. At what point do you lose sleep?

Here's another way to test your risk tolerance. This test also is taken from Evensky's book. (I generally don't think quizzes should be used to determine how to allocate someone's money. However, if used as a tool for further discussion and discovery rather than a final answer, they can be helpful.)

Source: Y2K and Your Money by Harold Evensky.

The final total is an estimate of the percentage of your portfolio you might comfortably invest in stocks.

Here's a description of the goals in the chart:

  • Capital preservation. Suppose you have $100,000 to invest today. How important is it to you that five years from now your investment will be worth at least $100,000? If your response is "extremely important," circle 6. If you think, "As long as it's worth a lot more in 20 years, I don't care what it will be worth five years from now," circle 1.
  • Growth. How important is it that five years from now your investment is worth more than $100,000? If your response is, "That's extremely important, after all that's what I'm investing for," circle 6. If, instead, you think, "I don't much care about growth. I just want to be sure my original principal is preserved," circle 1.
  • Low volatility. Remember the earlier discussion? Volatility describes the reality that investment values may change daily, even from minute to minute. Would you lose sleep if the value of your portfolio declined in value from week to week, even if the portfolio later recovered those short-term losses? Circle 6. If you know you would not pay any attention to your portfolio in the short term and instead would have confidence it would recover over time, circle 1
  • Inflation protection. Again, suppose you have $100,000 to invest. How would you feel if, five years later, your investment had grown in value but, because of high inflation, your money now bought less than five years earlier? Choose 6 if you believe it is vitally important to avoid this and a lower number if inflation protection is less important.
  • Current cash flow. Some people, particularly retired people, need to take money out of their investment portfolios in order to supplement their Social Security, pension or other noninvestment income. Most working investors have enough income from sources such as wages to allow all of their investment returns to remain in the investment portfolio for greater long-term growth. How about you? What percentage of your investment portfolio must you withdraw every year in order to maintain your current lifestyle? Divide that number by 2. Use the answer to determine which number, 1 to 6, to select. For example, if you need 12% of the portfolio's value per year, circle 6. If you need only 2% per year, circle 1.
  • Aggressive growth. I'm not talking about high growth, but rather aggressive strategies such as short sales and margin, or highly volatile investments such as commodities. Are you completely comfortable with such strategies? Circle 6. If the very idea makes you break into a cold sweat, circle 1.

Obviously this is not a perfect exercise, but it helps organize your thinking and provides a good backdrop for discussion. When you become the architect of an investment portfolio, risk is the most challenging issue to get right. A portfolio's best ally against risk is time. Time levels out the up and down markets. Regardless of how you define risk, it's really something you have to discover in yourself. If you are not sure, start with a lower risk allocation and ignore the high-octane performers. Some people learn the hard way by trying high-risk investments first. Not everybody can drive an Indy 500 car or handle a risky portfolio.

Most investment pros seem to say that timing doesn't work. Others claim that timing is everything. Who's right? Next week, I'll have some interesting information from an expert who tracks timers.

Vern Hayden is a certified financial planner with the American Planning Group in Westport, Conn. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. Hayden welcomes your feedback.

TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.