How Much Investment Risk Should You Take?

Source: flickr user Paul Cross.

Before you can invest responsibly, it's important to take a long look at your risk tolerance -- that is, how much volatility are you willing to deal with in the pursuit of investment gains? I wish there was a simple answer to this question, but risk tolerance depends on a variety of factors, including your age, your personality, and why you're investing.

Here's a quick guide to assess your own risk tolerance, and a few pointers to help you put a plan into action.

What is risk?
Traditionally, "risk" is equated with the word "stocks" when investing. When you are enrolling in a 401(k) for example, the stock funds are generally labeled as higher-risk than the bond and money market funds. A risk-tolerant investor might set up a portfolio consisting of 90% stocks, whereas an investor who doesn't want risk might only put 40% in stocks.

While this is generally a good principle, it's not a perfect rule. As we've written before, investing in bonds can be just as risky, especially in low-interest-rate environments like the one we're in now. After we discuss what makes up your personal risk tolerance, we'll take a look at how to find stocks that meet your desired risk level.

How to determine your risk tolerance
When figuring out how much risk you should be taking, there are a few things to consider.

• Your age: This is the single most-important factor in determining risk tolerance. Younger people, who have decades before retirement, can afford to take on more risk in the pursuit of long-term gains. On the other hand, investors who will need their money for retirement in a few years can't afford to withstand the effects that recessions and crashes have on high-volatility stocks.
• Personality: Do you like to live dangerously? Some people are just natural risk takers, and it's completely acceptable for their investment portfolios to reflect that fact (within reason). However, if the thought of your portfolio declining by $100 gives you nightmares, you should probably dial your risk level down a few notches.
• Why you are investing: If you're 30 and investing for your retirement, you have a time frame of more than three decades to work with, so you don't need to worry too much about temporary ups and downs. Conversely, if you're 40 and planning to send your child to college in a few years, you shouldn't take unnecessary risks with money intended for that purpose. Always remember the reason you're investing the money when determining how much risk you should take.

One popular rule of thumb is to take your age and subtract it from 110 to determine the percentage of your investments that should be in riskier assets like stocks. I like to modify that rule a bit -- take your age and subtract it from 110, and then adjust that number up or down depending on your own personality and investment objectives.

Not all stocks are equal
Some stocks are extremely low risk, while others are just as risky as buying a lottery ticket. Investing your retirement savings in stocks like Johnson & Johnson and Coca-Cola is one thing -- sinking your nest egg into First Solar and Netflix is quite another.

In order to get a good idea of how risky a stock is, take a look at its beta, which is a metric listed in most stock quotes. Basically, a stock's beta tells you how reactive it is to market movements. A beta greater than one means more volatility (riskier) and a beta of less than one means less volatility. For example, a beta of 1.5 means that, when the S&P 500 drops by 1%, that stock could be expected to lost 1.5%.

To put this in perspective, here are the betas of some popular stocks.

It's also worth mentioning that, just because a stock has a low (or high) beta doesn't necessarily mean that it's a good (or bad) long-term investment. It simply means that it's not a terribly volatile one. There are many other factors to consider before investing, including (but not limited to):

• History of profitability
• History of growth rate
• Current valuation
• Dividend history
• Sustainability of business

In other words, after you determine your risk tolerance, and which stocks best fit into it, you need to do your homework. Here's a discussion of some of the best low-risk stocks for the long term to help get you started.

There is such a thing as too little risk
It's also important to mention that there is such a thing as too little risk. Even if you consider yourself to have no risk tolerance whatsoever, the best move is not to simply stick your money in a savings account -- inflation alone will erode your purchasing power.

Historically, inflation has averaged just more than 3% per year. This means that if you stick $100 under your mattress, it will have roughly $40 in purchasing power in 30 years. At the bare minimum, your goal should at least be able to keep up with inflation, which even the most cautious investors can accomplish using long-maturity Treasury bonds, and similar investments that are virtually risk free.

The bottom line: There's no "one size fits all" approach
I wholeheartedly believe that stocks should make up the bulk of most investors' portfolios, as there is a huge range of possible risk levels within the stock market, and it offers the best combination of growth and income of any asset class.

There is no single correct answer to the question, "How much risk should I take on?" The smartest thing to do is to come up with a risk level custom tailored to you, and then choose your investments accordingly.