OK CLASS, let's start this lesson with a simple, multiple-choice question:
You've saved for a big European vacation. Two weeks before your departure, you lose your job. Do you:
a. Cancel your vacation?
b. Make plans for a modest vacation at the beach instead?
c. Go as scheduled, reasoning that job hunting will go better after a little R&R?
d. Extend your vacation and plan a real blowout; this might be your last opportunity to go first class?
What's this got to do with investing? We were wondering the same thing after we read it on another personal-finance site. It's part of a fairly typical interactive quiz titled, "How Much Risk Can You Handle?" The quiz aims, it seems, to gauge your capacity for stupid behavior more than your capacity to invest in the stock market. Another question begins this way: "You invest $10,000 in a stock that drops 10% the next day ..." You can almost hear Jack Nicholson in the background: "You want risk? You can't handle risk."
Risk is a fact of life for any investor. Stocks plunge. Companies go bankrupt. Bear markets linger. There's even risk in doing nothing: Thanks to inflation, $100 left moldering in the bank earning no interest will be worth about $75 in 10 years. To earn the highest rewards, you have to assume a certain amount of risk. If you minimize your exposure to the perils of investing, then you have to accept lower returns.
The past few years have given investors a strong lesson in risk.During the late 1990s, most investors thought they had a great tolerance for volatility. But after a protracted bear market, some of those very same investors had zero risk tolerance, and today they may still be missing out on the market's gains. For most of us, the right place is somewhere in the middle. Recognizing the dangers that exist, you simply have to follow some easy strategies to protect yourself. Remember, investing is a time-tested way to make money, not some frat-house measure of machismo.
We'd like to get you comfortable with the idea that "risk tolerance" has more to do with time than temperament. As our interactive Time vs. Risk lecture will explain, the more time you've got to make up for short-term losses, the more aggressive you can be with your investments. Of course, the opposite is also true: If you're saving for a short-term goal, then it's best not to bet the ranch on, say, a small-cap tech stock.
We'd also encourage you to take a walk through our Stock Market Chamber of Horrors. It'll demonstrate how some of the market's worst disasters could've been averted simply by being patient, thinking defensively and not exposing yourself foolishly. When you're done, check out our Defense Is the Best Offense lecture for a primer on how risk-limiting strategies like asset allocation, diversification and dollar-cost averaging work.
