Consider Your Tolerance for Risk Before Investing

A few weeks ago, a wealthy 65-year-old man walked into Heidi Steiger’s office and demanded that she take his $2-million account out of Treasury bills and throw it all in the stock market.

Steiger, managing director of individual asset management at Neuberger & Berman in New York, said no.

“I told him that if he wanted to invest half of it in stocks and half in bonds, we would have something to talk about,” she said. “But here was a man who had never taken any risk at all and he was talking about going to the opposite extreme with money he couldn’t replace if he lost it.”

This wealthy man is only indicative of what thousands of investors are doing these days, Steiger said. They’re fed up with low yields on certificates of deposit and Treasury bills, so they’re flocking to the stock market, which has posted a much more impressive performance lately.

Many have no real concept of the risks they’re taking. Indeed, experts maintain that an individual’s ability to tolerate risk is one of the most important factors in determining how they should invest. No matter how they choose to invest their money, they should realize that they are taking some risk, although the amount and type of risk vary greatly with the type of investment.

Those who invest in insured bank deposits, Treasury bills and bonds, for example, are not risking their principal because the investment is backed by the full faith and credit of the U.S. government. But they may find too late that their investment return didn’t keep pace with the rate of inflation.

Those who invest in the stock market, on the other hand, are always risking their principal. But over long periods of time, their average investment returns usually beat the rate of inflation.

To invest well, individuals must always consider their risk tolerance--how willing and able they are to gamble with their money. If they don’t, they’re likely to make thoughtless errors that can cost plenty.

You measure your risk tolerance by a handful of factors, including your age, your level of affluence, your sophistication about the financial markets and your psychological makeup. While the first three are relatively easy to measure, the fourth is perhaps most important, Steiger said.

Investors who are uncomfortable with a particular investment--whether or not the discomfort is reasonable or justified--are likely to make all the wrong moves. They’ll sell stocks when prices hit their lows and they’ll buy when the prices are high--exactly what you don’t want to do for the sake of your investment return. They’ll lose sleep over a marginally higher investment return.

Because risk tolerance is very personal, there’s no standard formula for investing money. Instead, there are literally thousands of variations on the same theme: The younger and more affluent you are, the more risks you can take. But no one should put all of their investment dollars in high-risk ventures. That’s the short-cut to poverty.

Steiger suggested that investors start with low-risk ventures and when they have enough to take risks, start putting additional investment dollars into slightly higher-risk ventures. Think of it as an investment pyramid, she added. Cash and short-term Treasury bills are the bottom level of risk; up a step are high-quality fixed-income investments, such as government-backed mortgage securities, high-quality corporate bonds and commercial paper.

The next step might include certain life insurance products and high-quality stocks. Then come more speculative stock investments--such as stock in small, thinly capitalized firms. Lower-grade bonds and international stocks and bonds would also fit into this category.

Finally, you get into much riskier investments, such as commodities, limited partnerships and stock options, to name a few.

You should have progressively less of your assets in investments high on the pyramid. And some people--particularly those older or unable to risk their principal--should avoid the top tiers completely.