Step 2 - Are You A Conservative or A Risk Taker?

by: Daniel P. Matthews

Everyone is willing to take risk - as long as they don't lose anything! But, some people are willing to lose everything if they stand to gain enough. That is the pickle you face in deciding how to invest your money.

On the one hand you could convert all your money to cash and carry it with you. You might think that would eliminate your risk. It does not. You could get mugged, everything would be lost. If you don't get mugged and you carry it with you, you earn no interest and that means you do nothing to offset the effects of inflation. So, carrying your money with you isn't prudent.

On the other hand you could invest your money. Savings banks, for example, will pay you interest of 2, 3, perhaps 4 percent. Certificates of deposit can stretch your return to 5 or 6 percent, maybe more. As long as the inflation rate is lower than the interest rate the bank pays you, you are increasing your money.

Most banks are low risk - generally, your money is safe. Still, you should be mindful that banks have failed - as a matter of fact in the 1980's many banks went under!

You can mitigate the risk that your bank might go under by making sure it is protected by the Federal Government. Even then, there is limit to how much protection you get from the Government. Anything over the insured amount (usually $100,000) is fully at risk!

But, you want your money to grow as quickly as possible. A bank's rate of 2, 3, 4, or even 5 percent is incredibly low. Risk is driving your decision to accept the bank's incredibly low offer or investing your money in other opportunities.

Here are some key elements that drive people to be more risk tolerant than other people:

The first element is age. The younger you are the more time you have to recover if an investment turns sour. The older you are the more likely it is that you want a consistent flow of income. Your desire for current income tends to make you risk adverse.

Why does age and time have this effect? Our model helps demonstrate the point. Remember, our model (take me to the model) establishes a goal of $5,200/year in additional income. If you held money in a savings bank and that bank paid 3% on your money, you would need $173,335 in savings to generate the desired $5,200 annual income. The need for that annual income is soundly met by the savings bank scenario just discussed. However, you need to understand there is still an amount of risk in the scenario.

The Government more than likely insures up to $100,000 in your savings account. You would have to manage the risk of having $73,335 more in savings than is Federally insured. The risk is reduced by opening another savings account at a different bank and splitting the money so neither account has more than $100,000.

Another factor that drives risk tolerance is how you feel about certain outcomes of financial transactions.

Your reaction to the potential outcome of a financial transaction is reflected in the way you buy car insurance. Do you buy the minimum amount of car insurance and trust that things will work out? Do you buy the maximum amount of car insurance and sleep comfortably knowing you're covered? Do you trade-off the monthly payment with the amount of the deductible? The answer to these and some other questions will help you understand whether you are a risk taker or risk avoider!

Also, your experience with investing drives your risk tolerance.

People who understand stocks, bonds, mutual funds, real estate, etc., are more likely to consider the return that these investments can produce. Without experience, you do not know the possible outcomes of these types of opportunities. Without the experience, you are apt to ignore them all together. The solution is to reduce this risk through learning about the opportunities, then using them, when appropriate, to your advantage - to get a higher return than the bank pays on your savings.

Okay, here are two final thoughts. First, send me an email and I will send you a little questionnaire to help you gauge your risk tolerence.

The second thought is about the earlier discussion refering to savings banks. Savings banks used to give personal loans for 8, 9, 10 percent. Now, they issue credit cards for 15, 18, 20, even 21 percent and more . They pay you an incredibly low five percent and charge you fifteen or more percent! That means they are making 10 or 13 percent, even more, on the money in their bank! If banks can get that kind of return, so can you! Yes, you can! Minimize the amount of money you have in banks to the money you need short term. You know, paying bills, sudden emergencies, etc. Put your money to work for you, not the bank!

Go to step three now.