By Paul Commins (TMF Buster)
October 9, 2000

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Here at The Motley Fool, we probably don't write about investment risk often enough. Given its fundamental importance to our target reader, the family money manager, you might expect us to deliver comprehensive risk lessons on a daily basis. There are two major reasons why this doesn't happen.

First, the fundamental laws of investment risk don't change much over time. In general, investment returns have always come in "plus or minus" bands. If you decide to aim for higher returns -- to stretch the imaginary band that captures your future bottom line -- you must accept that the band stretches both ways. The potential for greater profits always goes hand-in-hand with the potential for greater losses. When it comes to investing, this law is as fundamental as gravity.

Second, discussions of investment risk tend to get complicated in a hurry. The core lessons are quickly buried in a mountain of facts and figures. While useful to all, and even interesting to some, these risk debates are also great for scaring off beginning investors. Finding himself buried in strange ideas and convinced he is not worthy, our latest investing pupil may abandon his education, we fear, and return the whole of his financial future -- like a chunk of active uranium -- to the care of others.

Such is the balancing act we face on a daily basis, here at Fool HQ. We want to be your trusted investing partner, and that means sharing the cons along with the pros. On the other hand, we believe in your ability to invest successfully on your own, and we don't want to scare you away. In this spirit of balance, then, we present two risk-related questions you should always ask yourself before making any investment. They may appear simple, but no other investment angle is as important.

Question 1 - When are you likely to need this money?
In general, the longer you keep money in the stock market, the lower your odds of losing it and the better your odds of beating low-risk bond rates. Time has great power to modify investing gravity -- the fundamental risk/reward tradeoff -- in your favor. If you watch the stock market too carefully, it'll scare you to death. It swings wildly, but over time it has always gone up and, for the most part, it has carried long-term investments well beyond bond returns.

Think of it this way. Allow your toddlers to make mistakes and they'll be all over the map in the short term. At times, more carefully controlled tots will outshine your struggling kids. In the long run, however, your flexible, well-tested offspring are likely to have greater growth potential. You may just have to wait longer to see it.

In the same way, if you get too bold with your stock investments you might run into the investing equivalent of mismatched Grranimals or a temper-tantrum at the mall. Unexpected expenses could force you to cash out of your stock investment on someone else's terms, before the planned date. If this happens, you could get a rude introduction to volatility, discovering that not only have you failed to beat bond rates, but that a large chunk of your savings has actually disappeared.

The larger your emergency savings buffer and the more distant your financial goals, the safer are your stock market investments. So be sure to ask yourself the first question before you invest, and give yourself an honest answer -- one that accounts for potential emergencies.

Question 2 - What would happen if you lost this money?
The first question is essentially a probability question. It deals with the odds of investing success versus time in the market. This second question covers a completely independent dimension -- severity. In other words, it's not about whether you'll beat the odds; it's about what will happen if you don't.

Not all one-in-a-hundred bets are created equal. This is a facet of investment risk that is often overlooked. In fact, it's often overlooked even in statistical practice, where the tendency is to focus on the risk of making a mistake versus missing an opportunity. Different investing scenarios call for a different balance between these risk alternatives.

The twenty-year odds of making money in the market may be strongly in your favor, but they don't adjust themselves depending upon the importance of the bet you're making. You may be willing to put a big chunk of your retirement savings on the line in hopes of quitting the rat race sooner or building that dream home in the country. If you do, though, remember that the market can't tell this money from the remaining chunk -- the piece that will pay for your old-age room and board. You might want to bet this chunk differently.

By the same token, it may be worthwhile to put junior's college savings on the line, hoping for the Ivy League, but you won't be very happy if the sheepskin days arrive and you can't afford to help him with a bus ticket. Lady luck doesn't recognize the difference between the basics and gravy-time, but you should.

Consider this: What if you hit the big time, had a million in the bank, and were able to meet all of your future financial goals with the whole wad in low-risk bonds. Would you put any of it in the stock market? In the right crowd, this question would touch off a rousing debate. The answer isn't necessarily simple. But, this isn't the right crowd, so I won't attempt to offer an answer here. You might think for a moment, however, and form your own opinion about the idea of risking money to make more money, when you have enough already.

The bottom line
We all tend to focus our investing energy on finding the next great company to buy. Let's face it. It's fun. But, if you really want your investing life to be fun, in addition to successful, don't forget to ask the two big questions before you get started. They may be uninspiring and downright dull, but they're more important than anything that follows.