Determining Your Risk Tolerance

Many investment advisors have developed questionnaires designed to help determine an investor's risk tolerance (a Web search will give you lots of examples of questionnaires you can take online). They vary from the brief to the meticulous, but they all tend to feature similar kinds of questions and attempt to place you into one of three categories based on your investment risk tolerance:

• Conservative investors are those who put a premium on conserving their capital and are willing to accept lower returns in exchange for safety.
• Aggressive investors seek to get the highest possible growth in value from their investments and are willing to risk suffering losses in the short term to meet their objectives.
• Moderate investors are (surprise!) somewhere in between.

How Much Debt Can You Handle?

If you feel that you have too much debt, you are not alone. Most people have substantial debt; many have more than they can handle. However, debt is not all bad. Sometimes it makes sense to use borrowed money for investments. However, most folks are not using debt in that way; they are using it to make ordinary purchases of things they would probably be better off without, anyway. In our competitive society, spending has become a status symbol. This encourages people to spend more than they should -- more than they have. Consequently, they run up tremendous debt.

While some debt is okay, too much debt is not. So, how do you know whether you have too much debt or not? First let's look at the different kinds of debt we might incur.

Measuring the Cost of Money

Interest is the charge added to a loan that makes up the cost of money. Interest is usually expressed as a percentage of the loan principal. The principal is the original amount of the loan. The interest rate tells you what percentage of the unpaid loan will be charged each period. The period is usually a year but may be any agreed-upon time. Here is how it works. Let's say you loan your friend $100 at 5% annual interest. At the end of a year—the period—you should receive $105, or $100 of principal and $5 interest. Simple, isn't it?

Let's say your friend doesn't repay the $100 principal, but pays you only the $5 interest; then the next year your friend will still owe you the $100 plus another $5 in interest. The preceding is an example of simple interest. Simple interest is the amount of money to be paid each period on a principal amount due.