The amount of risk you are willing to take is an extremely important factor to consider before making an investment because of the severe consequences of taking on too much risk. Risk is uncertainty—the possibility that the investment won't perform as expected. Most investors who take on too much risk panic when confronted with losses they are unprepared for, and they frequently bail out at the worst possible time. Stock investors who panicked and sold right after a stock market crash moved out of the market at one of its lowest points. The result—buying high and selling low-is the opposite of Will Rogers' famed investment advice, and is guaranteed to produce an unhappy outcome.
Properly assessing your tolerance for risk is designed to prevent you from making panic decisions, abandoning your investment plan mid-stream at the worst possible time. How can tolerance be measured?
While many questionnaires seek to grade risk tolerance, the best approach is to simply examine the worst-case scenario—a loss over a one-year period—and ask yourself whether you could stick with your investment plan in the face of such a loss.
Investors with a low tolerance for risk generally can sustain losses of no more than 5% over a one-year period. Individual securities with this kind of characteristic include money market funds and certificates of deposit, both of which protect the underlying principal investment with virtually no risk of loss, and short-term bond investments.
Investors with a moderate tolerance for risk can generally withstand losses of between 6% and 15% over a one-year period. Types of securities that may sustain these kinds of losses include intermediate- and long-term bond portfolios and high-quality, lower-risk dividend-paying stock portfolios.
Investors with a high tolerance for risk can generally withstand losses of between 16% and 25% annually. Security types that may sustain these kinds of losses include aggressive growth stock portfolios, portfolios of stocks of smaller firms and emerging market stock portfolios.
Note that the examples of security types are presented merely to give you an idea of the level of losses discussed. If you are drawn to one of those kinds of securities, you probably have a tolerance for risk approaching that type of security. The examples are not meant to limit investors solely to the choices within each risk level. In fact, we shall see later in the series that even a low-risk investor can benefit by diversifying into riskier investments with part of their portfolio while maintaining a low-risk profile. In addition, the losses outlined are typical for the security types as a group; individual securities within these types could sustain losses much greater than a portfolio of securities.
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