This Risk Will Come Back to Bite You

Anybody can invest all their money in stocks. It's a lot harder, though, to keep all that money invested through the ups and downs that the stock market will throw at you over the years.

Those concerns lead most investors to adjust their portfolios to control their risk. But how can you be sure that the amount of risk you're taking is appropriate for you? Trying to gauge risk tolerance has challenged investors and financial advisors alike for decades.

The old risk questionnaire
If you've ever dealt with a financial advisor, you're probably familiar with the fabled risk questionnaire. They're often only a single page long, with a range of hypothetical questions that supposedly tell you how willing you are to put your money at risk.

Too often, though, such questionnaires give an inaccurate reading of just how much risk you can endure. A study from a recent issue of Money discussed how big a disconnect there is between the amount of risk many people think they should take versus what they can handle emotionally during down markets.

In particular, many advisors will recommend that younger investors put most of their money into the stock market. Yet according to a research company cited in the article, FinaMetrica, very few investors -- just 7% -- are equipped to deal with the volatility that results from having as much as 75% of their portfolio invested in stocks. Just one in 100 investors can handle an 87% stock exposure.

Lots of different risks
Another problem with assessing risk is that there are so many different types of risk that investors face. Although most people focus on overall prospective losses, there are other twists on the concept of risk that you might not immediately consider.

For instance, missing out on gains can be even more damaging than incurring big losses. Part of the reason for taking big risks in stocks is to reap potentially huge profits when you choose wisely.

Some people, though, can stomach risk on the downside but like to take profits early. That particular type of risk aversion can turn speculative investments like the ones many investors took in stocks like Ford Motor (NYSE:F), MGM Mirage (NYSE:MGM), and Bank of America (NYSE:BAC) into losing propositions: You still risk your whole investment, but you reap only 50% or 100% gains, rather than the four- and five-baggers you would have gotten if you'd stuck with those stocks throughout the rally.

Lacking conviction
In addition, even when you make good investment choices, they don't always reward you immediately. For instance, if you had bought the following stocks a year ago, you would have been sitting on some serious losses by early March. If you weren't prepared for such losses, you might have dumped your shares. Yet just look at the gains you would have missed by selling at what would eventually prove to be exactly the wrong time:

Source: Yahoo! Finance.

If you can't handle risk, you really need to know it before you invest. Otherwise, the mistakes you make will prove incredibly costly: You'll not only suffer grievous losses on the way down, but you'll also end up watching from the sidelines as those stocks recover.

You're far better off never taking that excess risk in the first place. Even if it means you give up some potential return, you'll also avoid those costly errors -- errors that often cause the most damage to your portfolio over the long run.

Be smart
There's no shame in lacking the risk tolerance to invest a huge portion of your money in stocks. All it means is that you may have to make changes in other areas, such as how much you save or the lifestyle expectations you have, in order to compensate for the lower returns you'll earn over your lifetime. Most importantly, the sooner you set reasonable expectations for the future, the easier it will be to build a strategy that will help you reach your goals.

Do you think risk is dead? Think again. Read what Jim Mueller thinks are the four most dangerous words for your portfolio right now.