Are you waiting on the dice to roll in Las Vegas?

At 3,000 feet, hands on the wing strut, wind in your face, you pushed into space. Spread-eagled, you shut your eyes and prayed! Thankfully, the static line automatically opened your parachute. You were alive and euphorically floating to a successful landing.  After an hour of training at Wallerfield, you had the courage to jump. The risk of jumping off a plane with a parachute is losing your life. But the first-order risk — in life and in investing — is in not understanding risk. If you believe you are ready to make a commitment to investing, and if you believe you have the courage to stand by that commitment, then you need to be prepared to take some risk. What exactly does that mean?

To be as clear and direct as possible. There are two basic financial risks to investing: the risk of losing your money and the risk of losing an opportunity to make money. The two risks are in conflict. If you try to make money through certain investments, you could lose some or all of the money you invest. If you keep your money completely safe, you may miss out on the chance to earn good returns through investing. The challenge of investing is to try to give yourself the chance to make money while minimising the risk of loss by building in downside protection. That’s what a good defense is all about. Beyond the risk of lost money and the risk of lost opportunity, there is a third risk you must consider: the psychological risk that you can’t handle the amount of risk you’ve taken.  This is your risk tolerance. A game plan must strike the right balance for you between the two financial risks given your personal risk tolerance. How you go about balancing the two financial risks depends largely on your goals.

The Guesswork of Risk
There is a lot of guess estimating with risk. Since risk is all about what will happen in the future, the outcome is uncertain. They say you can’t get reward without risk, but just because you take risk doesn’t mean you’ll get rewarded for it. What gave you the courage to do something that scared you? It probably had something to do with faith and trust. Theologians define faith as the substance of things hoped for and the evidence of things not seen. Trust is when you believe that somebody, including yourself, can and will do the right thing. You have faith in a result and trust in somebody to make it happen. This article is about helping you figure our how much risk you can handle so that when you create a financial plan you’ll be able to trust yourself to stick with it, and you’ll have faith that it will be worth the risk.

Gap Analysis
Your investment portfolio carries risk. You have a certain risk tolerance. The question is: Does your investment portfolio’s risk match your risk tolerance? Too often the answer is no. Rather, there’s a gap between the two, as financial planning researchers describes it. Your goal in developing a financial plan is to close the gap, that is, to align the risk profile of your portfolio with your risk tolerance. To close the gap, you first need to identify how large it is. That task involves knowing both the risk profile of your portfolio and your own risk tolerance. In later chapters we discuss the risks of various investment portfolios. This article is about sizing up your personal risk tolerance.

Reasonable versus Extreme Risk
Once you have a sense of the funds you can spare for investing, you’ll need to decide just how much risk to take with those funds. Unfortunately, all too often people skip this step. They think of investing money like gambling money. Once they decide how much they’re willing to play with, they’re willing to risk it all. The second-largest tourist attraction in the world is Las Vegas. (The first, by the way, is Mecca.) And that’s no coincidence. Vegas is all about short-term thinking — the most natural way to think when it comes to money. In Vegas people roll the dice, spin a wheel, pull a handle, or play a hand, and voila — instant gratification — win or lose!

The builders of the Vegas casinos knew how to stack the deck in their favour. Sure, there’s some skill involved, sometimes. But most of the time if you win it is because you are lucky. Most of the time people take huge risks and sustain huge losses. If you want the instant gratification that comes with gambling, do it in Vegas. The only way to get immediate gratification in the markets is through extreme risk, like betting a bundle on one small up-and-coming company’s share. Extreme risk is like roulette: It offers a chance at a super-high return if you bet right, but there is also an extremely high chance of total wipeout. The stock market is not a place to fool around with extreme risk. If you as an individual are going to invest your and your family’s money in the market, you should subject it to only reasonable risk.