Investing: Determining Your Risk Tolerance

Investment risk tolerance is a measure used by investors and financial planners in investment planning. The risk tolerance scale is also a useful risk management tool and ranges from low to high with the lower end of risk tolerant investors choosing financial instruments such as insured bank accounts or financial instruments and/or guaranteed investments such as certificates of deposits, bonds and money market accounts.

These basic types of risk are also comprised of more in depth risks that once elaborated upon sometimes change the actual risk level of some financial instruments that may usually be classified as low or high risk. This article will discuss the types of risk tolerance, risk types and provide tips on determining individual risk tolerance.

How to determine risk tolerance

To find an ideal risk level involves assessing and combining 1) financial goals, 2) personal perspective, and 3) life decision history with the realities of the financial markets such as percentage price losses, market volatility, personal comfort and amount invested. A simple way of looking at risk tolerance involves identifying how much general risk one likes to take financially in terms of a low to high scale.

The following link provides an example of a basic risk tolerance scale. This scale does not illustrate the types of investment associated with each type of risk, however additional graphics do, this risk/investment pyramid being one example. The difference between the scale and the pyramid is that the pyramid includes investments associated with each level of risk. However, what the pyramid does not illustrate is the finer details within each risk group and investment choice.

Investments are not always as black or white; or right or wrong as some risk illustrations seem to imply. This is because there are different types of risk within each risk category. For example, of the lowest risk level, which bonds are the safest? or which companies providing certificates of deposit are most financially solvent?

What may seem to be low risk, might actually be quite a high risk if the financial institution(s) issuing the investment instrument are doing so with a low credit rating or precarious business financials. This is why it is important to look beyond the simple risk diagrams often used in determining risk tolerance.

Types of risk and individual investment choices

As we have seen, there are essentially between three and five types of risk that may include very high, high, medium and low. To identify which one is most comfortable think back to times when such risk was occurring in life. For example, one might think about questions such as how it felt, what was the response to it, was it easy to stay emotionally balanced during the risk and what happened next.

Once one has an idea of what kind of risk one feels comfortable with, the next step can involve applying those thoughts and feelings to one's finances. Would it feel the same to have such risk levels in one's financial investments and what level of risk would be right both in terms of financial needs and goals. To further illustrate the types of risk one may be exposed to it can be helpful to understand which investment circumstances are affiliated with each type of risk.

• Financial market risk

Each financial market has a different level of risk per se. For example, the bond market tends to be more predictable and provide more stable outcomes than stock trading, but has less potential for gain. Furthermore, the Foreign Exchange market can be thought of to have high risk as the chance of losing money in this market can be high just as the chance for making money can be great. Choosing which financial markets to invest is a way to invest with risk in mind.

• Price volatility

When investing in the stock market, prices can be volatile within double digits percentages either up or down within as little time as a few hours. This can mean an investment could lose as much as 20% or more if an adverse event, sudden unfavorable economic news or weak market conditions strike one's investment. Being prepared both financially and mentally for such risk is a key part of risk comfort. If one would rather not expose oneself to such risk there are other ways to invest and avoid such risk.

• Investment choice

The choice of one's investments is also a way to identify and invest with risk in mind. Bank insured and guaranteed investments are among the safer of investments, followed by treasury bonds, conservative mutual funds, blue chip stocks, growth stocks, and futures trading in that order. One may wish to try a little in each to determine what one feels most comfortable with before deciding which risk level is right.

Tips for determining risk level

• Market simulations may help one get the feel for which type of investing one is comfortable with. Such programs do not involve real cash are thus risk free, but help one identify potential risks and pitfalls within that financial market.

• Invest Conservatively at first to see how it really feels, to make and lose real money. The first hand experience shows what is really involved both financially and mentally.

• Personal history of decision making is a clue to one's risk preference. In life many decisions and choices are made, if such choices were often risky or less risky, this may be a good indicator of what type of investment risk one will prefer.

• Study and research investment choices and financial markets to garner a more exacting level of risk. Each market and investment has a life of its own and may not always be a good predictor of other similar investments.

Investment risk is something one may intuitively know beforehand or have to think about before investing. If one has to think about it a lot, this may imply one is naturally cautious regarding investments. However, caution alone may not determine risk preference. The above illustrations and tips can assist with such identification of risk levels, how to deal with those risk levels and which investments are more likely to yield each risk level.

Why Invest in a Mutual Fund? What are the Advantages and Typical Returns?

Mutual funds are managed investments that diversify a large pool of investor's money into a number of investment vehicles. There are advantages and disadvantages to investing in mutual funds, and these pertain in part to investment risk, yield, opportunity cost, fees, and financial planning. This article will outline some these pros and cons of mutual fund investing in addition to giving examples of various types of mutual funds.

Types of mutual funds available

When it comes to mutual funds there are a sizable number of choices to choose from. Some mutual funds specialize in emerging markets, others specialize in commodities, some in stocks and bonds and so on. The historical performance of a mutual fund varies from fund to fund.

Additionally, different fund managers may use different investments strategies and styles for similar types of mutual funds. Thus, the fund management is also a relevant factor in how a mutual fund will do. Some examples of mutual funds are illustrated below to demonstrate the wide range of investments a mutual fund can make possible that may not otherwise be possible via investment alternatives.

• Fidelity ContraFund (FCNTX): Invests in large capitalization companies
• ProFund Ultra Short Japan Inv (UKPIX): A mutual fund that invests on a decline in Japan's financial markets
• Dreyfus Premier Emerging Mkts Opp 1 (SEORX): Specializes in large capitalization emerging markets
•PIMCO Commodity Real Return Strategy Fund (PCRAX): A mutual fund focused on commodities investments, specifically natural resources.
• Summit Nasdaq 100 Index 1 (SANIX): A fund that invests in the 100 largest NASDAQ stock exchanges companies

Risk, fees and yield of mutual funds

Fees associated with mutual funds can also vary. A mutual fund may be a no load, front end or back end mutual fund in addition to having annual maintenance fees which vary among funds. No load funds do not charge fees for certain requested by the mutual fund owner such as buying and selling of the mutual fund.

Front-end mutual funds charge a fee and/or commission upon purchase but not upon sale whereas back end mutual funds do the reverse. Assessing the scale and amount of mutual fund management fees and charges in relation to their cost and percentage yield is an important calculation to consider when choosing mutual funds.

Mutual funds are generally a lower risk choice of investment than direct investment in options, commodities and some types stock investing. This is primarily due to 1) the professional management of the fund and 2) the diversification of risk over a number of investments. These two factors can make mutual funds a useful part of an individual, estate or business investment strategy as it hedges against risk. However, investing solely in mutual funds may also create risk because mutual funds are not entirely immune from investment risk and may not guarantee returns or value of initial investment.

Alternatives to mutual funds

Alternatives to mutual funds include Exchange Traded Funds (ETF), Unit Investment Trusts (UIT), Treasury Inflation Protected Securities (TIPS), Real Estate Investment Trusts (REIT) and Certificates of Deposit (CD) among several other options be it via investment in physical property, business or asset classes such as art, antiques, or vehicles. In other words, the number of choices an investor has is broad, and mutual funds represent only a fraction of the available choices.

Consequently, being able to weigh the advantages and disadvantages of one investment over another is essential for investment success, risk level and investment goals. How well a mutual find is capitalized i.e. its size and capacity to invest, the performance of the companies and/or financial products the fund invests in, and the tax implications or lack thereof on investing through certain funds can all be relevant when choosing to invest in a mutual fund.

Family Investing Tips

When it comes to family, investment is includes more than just money. Family investing also involves anything intended to benefit a family's well being over time. Such investments add value to family life, family quality of living, and standard of living. In order to invest in family and/or for family one can benefit from considering how one invests, in addition to what and where one invests to maximize return on investment. This pertains to monetary and non-monetary investments.

• Choosing an investment

If one tries to invest too much or too little, one could burn out, run out of resources, not put enough into a family etc. For example, putting too much money into a 529 college savings plan may limit the growth opportunity afforded by less savings orientated asset allocations. In such case, at an early age financial instruments such individual retirement accounts and life insurance policies can be low cost and have long term benefits for parents and children.

In terms of non-monetary investments, choosing an investment one is able to reasonably make with a little more than what one usually does is a good place to start. For example, if one is a loving person, love is then an asset that is in good supply. The extra love one has can be reinvested in family to help them learn about love and grow love of their own. The same and similar principles hold true for other investment categories. Of course love alone does not necessarily make the world go around.

• Be willing to lose on the investment

Not all investments succeed or make money, this is a fact one should be fully aware of before investing anything whether it be time, money, energy, goodwill etc. Knowing how to deal with a negative investment and what to do when an investment goes down in value is just as important as any other part of investing.

Risk management is thus an important aspect of managing family investing i.e. not betting the farm on a high risk investment is generally a good idea. In terms of love, if one's love is continually invested over time with absolutely no return the investment may still not be a loss because 1) Love is free, and 2) Love can take years for the value of love to be realized. In such cases adjusting one's investment plan to include tough love may be helpful.

• Use an investment strategy

All good investors use tactics and strategies of one kind or another. The importance of strategy is highlighted by changes in market and economic conditions over time. As the financial landscape changes, it can be helpful if family investments change along with it to adapt to the new financial circumstances. This can help optimize investment performance.

• The big family investments

Often, the largest investments people make are the one's that deplete one's own resources the most. These investments are potentially the biggest sacrifices especially if they don't return a positive yield. Some of largest non-monetary investments family members and parents make include time, money and energy. These are investments because they can help a child grow with experience, knowledge and wisdom that parents offer them.

• Other non-monetary family investments

Time, money and energy wouldn't be complete without refining how they are allocated. For example, one could invest a lot of time doing nothing with a family member but that wouldn't exactly be productive other than in terms of companionship. Optimizing time, money and energy involves fine tuning the big investments into smaller investments. Some of these smaller investments include understanding, effort and love.

Summary

Family investing is more than just a monetary investment plan as family is about learning, growing, experiencing, becoming, changing and so many other important things. Investing in a family is something that is done with the risk of losing it all as with many investments. If one uses a good investment strategy and tactics however, this can lower the risk of both financial and other investments in and for family.

Family investing is a good thing, but it is important to keep in mind to successfully invest in family takes resources that one may or may not have or be willing to sacrifice. With a willingness to invest and invest wisely one can start by investing a little and then with time investing more for potentially greater returns.