Assessing Your Own Risk Tolerance

Typically, risk is defined as short-term price volatility or variability. But on a long-term basis, you can think of risk as the possibility that your accumulated real capital will be insufficient to meet your financial goals. And if you want to reach your financial goals, you must start with an honest appraisal of your own personal comfort zone with regard to risk.

Individual tolerance for risk varies, creating a distinct "investment personality " for each investor. Some investors can accept short-term volatility with equanimity, others with near panic. So whether you consider your investment temperament to be conservative, moderate or aggressive, you need to focus on how comfortable or uncomfortable you will be as the value of your investment moves up or down. If you can't sleep at night for worry about the value of your mutual fund shares, you already know the type of investor you are.

Keep a particularly watchful eye on the character of risk you are willing to assume, for there is no "riskless" investment. A common distinction is capital risk vs. income risk. While stocks have fluctuated widely in market value over the years (high capital risk), their dividends have grown quite steadily. Bonds have also fluctuated (moderate capital risk), but have usually generated a higher and more durable stream of income, and they therefore continue to be an important part of most sensible investment plans. And the capital stability of money market funds and bank deposits come hand in hand with yields that are lower, as well as much more variable (high income risk).

Mutual funds offer incredible flexibility in managing investment risk. Diversification and Automatic Investing are two key techniques you can use to reduce your investment risk considerably -- and reach your long-term financial goals.

Recognizing the type of investor you are will go a long way toward helping you build a meaningful portfolio of investments that you can live with.

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Managing Risk Through Diversification

When you invest in one mutual fund, you instantly spread your risk over a number of different companies. You can also diversify over several different kinds of securities by investing in different mutual funds, further reducing your potential risk. By diversifying the assets that you have available to invest, you have a greater chance of reaching your investment goals, without the need to constantly react to changing market conditions.

Diversification is a basic risk management tool that you will want to use throughout your lifetime as you rebalance your portfolio to meet your changing needs and goals. Investors who are willing to maintain a mix of common stocks, bonds and money market securities have a greater chance of earning significantly higher returns over time than those who invest in only the most conservative investments. Additionally, a diversified approach to investing -- combining the growth potential of stocks with the higher income of bonds and the stability of money markets -- helps moderate your risk and enhance your potential return.

Types of risk

All investments involve some form of risk. Even a federally-insured bank account is subject to the possibility that inflation will rise faster than your earnings, leaving you with less real purchasing power than when you started. Consider these common types of risk and evaluate them against potential rewards when you select an investment.

• Market Risk. Also known as systematic risk. At times the prices or yields of all the securities in a particular market rise or fall due to broad outside influences. When this happens, the stocks of both an outstanding, highly-profitable company and a fledgling corporation may be affected.
• Inflation Risk. Sometimes referred to as "loss of purchasing power." Whenever inflation sprints forward faster than the earnings on your investment, you run the risk that you'll actually be able to buy less, not more. Inflation risk also occurs when prices rise faster than your salary.
• Credit Risk. In short, how stable is the company or entity to which you lend your money when you invest? How certain can you be that it will be able to pay the interest you are promised, or repay your principal when the investment matures?
• Interest Rate Risk. Changing interest rates effect both stocks and bonds in many ways. Investors are reminded that "predicting" which way rates will go is rarely successful. A diversified portfolio can offset these changes.
• Currency Fluctuations. As the dollar rises in value, the value of overseas investments will decline, and vice versa. But, in this era of globalization, you don't have to invest in foreign securities to gain or lose from currency movements; many U.S. companies with foreign operations can be impacted by these fluctuations as well.
• Political Turmoil. At home and abroad, events in the political arena can encourage or discourage those who want to invest. This is also a consideration when investing outside of the United States.

No two companies -- or their stocks -- will be affected in exactly the same way if the government passes a new trade law. Likewise, two bonds may be impacted differently when interest rates rise. How individual securities react to changes can be the key to controlling risk in your reinvestment portfolio.

When you spread your investment dollars around -- owning more than one security or type of security at a time -- you limit the possibility that any one investment can wipe out your original stake. Better yet, you can actually increase your chances of a higher return while reducing the overall volatility in your portfolio. A decline in the price of one security may be offset by rise in another.

Mutual Funds and Risk

With careful planning, it is possible to take advantage of the diversity of funds available to create a combination of fund investments that not only fits immediate goals, but also plans for the future changes in an individual's needs, like a child's education or retirement.

In assembling a portfolio of funds, you can mix high-risk/high-capital growth funds with low-risk/ high-income investments in percentages that vary with your economic and life situation. Tax-exempt funds can be added if your tax bracket warrants them.

How you diversify and allocate your assets among investments depends largely on the time horizon in which you have to invest. Younger investors can generally afford to be more aggressive. Investors near retirement should shift to more conservative investments. But these are only generalities.

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