Drill Down: Find Your Risk Tolerance

Your returns will generally be higher the more risk you take. Risk means the possibility that some of the investments will go sour, and you’ll be left with less than what you expected. Risk is bad, but high returns are good. Unfortunately, you can’t get one without the other.

You can reduce risk by owning lots of different assets. That way, when some go down, you’ll likely have others that go up. This does not guarantee that your total portfolio won’t ever have a down year, but it definitely improves your odds a lot.

You need to accept some risk, or else you’ll be stuck with very low returns. For instance, stocks are riskier than keeping money in cash. Keep in mind, however, there has never been a 20-year period in which stocks overall lost money. Stocks have not only gained in value over every 20 year period, but their gains have always exceeded the rate of inflation. The same cannot be said of safer investments—their value sometimes is eroded by inflation.

Here’s a picture of the decision you have to make. The farther left on the chart, the lower your total investment in stocks. (When your percentage of assets in stocks is low, your percentage in bonds will be high.)

If you want a high average return, you invest mostly in stocks. (The heavy black line is higher, showing higher average returns, on the right side of the chart.) You’ll be living the high life in retirement, most likely. But, to get that high return, you’ll have to accept some stomach-churning busts. With 100 percent of your assets invested in stocks, you could well lose one-third of your investment value in 12 months. Will you be able to sleep at night if that happens?

This chart is based on historical data, but we cannot guarantee the future. If you take high risk, you may not get that high of a return. You might be unlucky and have much worse results, even in the long run. However, if you choose a less risky mix of stocks and bonds, your potential disappointment is lower. You just don’t have the chance of doing really, really well.

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Drill Down: Picking Your Investments

You are going to split your portfolio into two chunks: bonds and stocks. The stocks will be further subdivided later.

Your first step is to choose the allocation between stocks and bonds. Take into account how risk averse you are by placing yourself into one of three categories:

• Aggressive: I’m in the upper third of willingness to take risks. I don’t mind playing poker for money. I’m optimistic about the long run. If I have a bad result, I can shrug it off and keep going.


• Moderate: I’m in the middle third of willingness to take risk. I can have fun buying a lottery ticket, but I’d never spend much money gambling. If I lose money in an investment it shakes me up, but I try not to over-react.


• Cautious: I’m in the lower third of willingness to take risk. Playing poker or slot machines for money makes me uncomfortable, even for small stakes that I can afford to lose. I worry about a lot of things in my life, including family and work.

Now think about how many years you have until you will begin taking money out of your 401k plan. That provides us with the following table, showing how much of your portfolio you should have in stocks. Put the rest in bonds.

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