Quick 3-Step Test: How Much Investing Risk Can You Stomach?

By Reyna Gobel
July 11, 2013

When there were rumors that Ford and/or GM were going to go bankrupt, I bought stock in both.

I figured one company had to survive. I put in about a thousand dollars split evenly among the two. 

Did it pay off? It sure did. I doubled my money.

Was it risky? No question about it.

Both companies could have ended up in bankruptcy, and I would have been out $1,000. This is because stocks of bankrupt companies generally lose most of their value.

Before I invested a penny in General Motors (NYSE: GM) or Ford (NYSE: F), I had to consider whether I could afford to lose the $1,000 I invested if my hunch didn't work out. 

That's something everyone has to ponder before investing in the stock market. For me, it's what kept me from investing more money, even though the investment seemed like easy money.

So how do you determine how much risk is just right and how much will keep you awake at night? Ask yourself these three questions:

1. What do I need to survive?

Unless you're socking money away in savings bonds, savings accounts or money markets, you shouldn't invest any money you'll need in the immediate future. Once you've determined you won't need the money you're investing in the next five years, you can then determine how you'll want to invest the rest of your money.

You want to have money easily accessible for emergencies so that if you are laid off or the car breaks down, you don't have to dig into investments that have recently taken a hit. Some experts advise that you have six months' pay set aside that is easily accessible and in safe accounts.

2. What's my emotional comfort zone?

Even if you can afford to lose $1,000, you might get really upset if you did. It's okay to be a little unhappy if you lose money. But if it will cause long-term unhappiness, you should probably think about investing in mutual funds or bond funds versus individual stocks or bonds. The risk is generally much lighter. Your money will likely not evaporate completely, although it could drop in value.

Here's an easy way to determine how the loss of money affects you. Think back to the last time you lent money to a friend or family member who didn't pay you back. 

Did you lose a lot of sleep? If so, you probably couldn't handle buying single stocks or bonds.

3. Do I have a long-term purpose for investment earnings?

Once you've answered the first two questions you've established two things about yourself: You can pay your rent or mortgage if the amount you're investing completely disappeared, and you know if emotionally you can handle some level of risk. 

Now, it's time to look at long-term financial tolerance. Generally, part of your portfolio will be in investments such as money market and savings accounts and parts will be in riskier ventures such as stock mutual funds. But you always want to keep in mind the number of years until you need the money and evaluate on an annual basis how close you are to reaching your goal. The goal you’re trying to reach for is what will determine your investment strategy.

For instance, if you have a goal of paying off your home in five years and you know you’ll need $50,000 to do it, you’d want enough invested in CDs, money markets and savings accounts to guarantee the money will be there based on the interest earned. CDs may even be best because you can guarantee the interest rate and you know your time table.

However, if the goal was you’d like to pay off your home if you were able to earn 5 to 10% on your investments, you’d want a more balanced portfolio with mutual funds included. You’d put more money at risk, but you’d potentially get the reward you want. Review your goals and your risk tolerance annually.  

The Investing Answer: Take the answers to these questions with you to your next appointment with your financial advisor. Discuss your concerns and risk tolerance. If an advisor doesn't understand your feelings and goals, it's time to get a new advisor who listens and helps you make decisions you're comfortable with.

P.S.: Investing in the stock market can be harrowing. But my colleague Elliott Gue and his staff recently went looking for stocks that are so trustworthy, they can be held forever. Called the "Forever Stocks," these are world-dominating companies that pay investors a fat dividend, dig a deep moat around their business to fend off competitors and buy back massive amounts of stock, boosting the value for the rest of the shares. To learn some of these stocks' names and ticker symbols, click here.