Know Your Limits

Gauging how much risk you can handle is perhaps the key to investing success. Take on too little and you’re leaving money on the table because riskier investments generally return more over time. Take on too much and you may cut and run when markets drop, and end up selling at the bottom.

We’ve all suffered through a crash course in risk tolerance over the past couple of years. But it’s a slippery concept. Barry Greenstein, for instance, is a poker player by profession, so you might think he’d be prone to gambling with his portfolio. Instead, Greenstein buys utility stocks and municipal bonds, and says he follows his father’s advice: “You can play poker, but don’t trade commodities.”

Just because you enjoy living on the edge doesn’t mean you can handle speculative investments. And your appetite for risk may vary as often as you change your shoes; it shifts with your mood, your social setting, your knowledge of investing and, most important, what’s going on in the market. One study, published in the Journal of Behavioral Finance, showed that if the markets have been up for just a few weeks, people grow a bit hungrier for risk, says John Grable, a former financial planner and currently a professor at Kansas State University.

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Take our quiz. One way to get a handle on your own risk tolerance is to fill out a questionnaire. Such quizzes can be a useful exercise, but they’re often poorly designed or used inappropriately by financial advisers. Many are often based on false assumptions -- for example, that women are risk-averse or that “you can handle more investment risk because you love to jump out of planes on weekends,” says Grable. Advisers are required by law to have clients fill out questionnaires about their investment preferences. However, says Grable, these often end up filed and forgotten, and advisers rely on stereotypes and assumptions to design portfolios for their clients.

But we’ve found a quiz recommended by experts that may help you get a handle on your own risk tolerance. Created by Fina-Metrica, the quiz is available here. Without giving too much away -- we don’t want to bias your results -- the test asks questions about your attitudes toward loss, debt and different types of investments.

The results provide guidance about how much risk you should take in your portfolio. And, of course, we all think that’s critical to a million-dollar payoff. But Grable says that way of thinking gets things backward. “Risk tolerance just refers to your willingness to take risk,” he explains. “It’s not the same as your capacity to take risk.”

So if you have a well-diversified portfolio, plus a wad of cash and maybe a guaranteed annuity, you have a tremendous capacity to ride the ups and downs of the market. If you don’t -- and this was the “lesson of the century” for many investors over the past couple of years, says Grable -- you probably don’t have the capacity to handle a 40% drop in the market. That means you were a prime candidate to sell your stocks and miss the recovery.

Older and wiser. Intuitively, you’d think we’d grow less tolerant of taking chances as we age. But the opposite is true, according to a study published by the Association for Financial Counseling and Planning Education. That may be because as we get older, we have a greater understanding of investing, not to mention a bigger pile of assets, so we can handle more risk both financially and psychologically.

In any case, taking the test is a good starting point for measuring your own attitudes toward risk. And you should take it often, especially after the markets record big gains or losses. It will help you monitor just how risk-tolerant you are, and show you how fickle your own attitudes can be.

Kiplinger’s is partnering with Nightly Business Report on the “Your Mind & Your Money” series, funding for which is provided by the FINRA Investor Education Foundation. For companion video reports, tune in to NBR on your local PBS channel Dec. 14 and 28.