As we each choose a path to our investment goals, we must consider investment risk. If all we worried about was the rate of return then the lottery provides our greatest hope. Imagine, $1.00 in, with $14,000,000 out on a weekly basis! How about that for a return! On the other hand there is the metal box with our $20 bills hidden in the attic. Now that is safety! It is quite clear, we need some balance between return and safety, or between reward and risk. Let's consider this balance.

The lottery example raises the obvious question: what is the difference between gambling and investing? There are those who feel there is no difference, that one is as bad (or good) as the other. The late Benjamin Graham, dean of Wall Street and mentor to Warren Buffett, defined two ways to tell the difference. First, he said the security purchase must promise safety of principle, and secondly a reasonable return. Any purchase not meeting these two tests were speculation (a gamble). Any wager in a casino does not meet the first test since we can lose all of the principle. It also violates the second criteria since a wager can return many times the amount wagered. That is not a reasonable return.

In Graham's opinion, investments promising a return of over 50% a year were too good to be true. That means the risk is probably unacceptable. A more reasonable return viewed by Graham would be more like 5% to 30% a year.

How can we be reasonably sure that an investment promises safety of principal? One way is to pay a price that is low relative to other companies with similar earnings. Buy shares so cheap that any good news will drive the price up and any bad news will have little downside effect. This principle then satisfies both of Graham's investment criteria. It is indeed increasing the odds of success, which is simply good business. Not gambling. Warren Buffet defines investing as buying $1 in company value for 50 cents.

We have all been taught to choose our investments in a way to maximize "expected return" within our own "tolerance for risk." Most guides deal only with the "expected return," without saying much about risk tolerance. I suppose we're supposed to go away and get our own feel for whatever that is. However, few of us really have an accurate understanding of what our own risk tolerance is. The result is we may steer clear of many higher-return investments because we've heard they are more "risky."

What is risk in the market? Traditionally, "risk" has been tied to the "volatility" of prices which is a measure of how much the price fluctuates around its average value. The assumption is that the more volatile the price, the riskier the investment. We know that to be untrue with our experience playing rolling stocks. Volatility is the meat upon which we feast. A changing price does not increase the risk! That is true in both short-term rolling plays and in a buy-and-hold strategy which waits out the fluctuations in price.

The risks we must consider as we make investment decisions deal with those events that can occur over which we have no control;

1. Market risk - This is always a factor, the likelihood that the general market will decline (remembering, that it always goes up again). We understand that about 70% of the stock price is tied to the general market.
2. Interest rate risk - This is the likelihood that interest rates may rise and decrease the value of our investments.
3. Opportunity risk - With money in low yielding, secure investments, we miss out on the chance to make more. This is the problem with the money in the metal box. The longer we tie up money in long-term contracts, such as long-term CD's, the higher the opportunity risk. We should use money-market funds only as short-term vehicles waiting to put the money to work at market lows. In our rolling strategies, when a roller doesn't, that is, does not turn back up from support, we can hold on waiting for it to do so or get out and back in to a better position to minimize this opportunity risk.
4. Cyclical risk - The risk that the industry your security is in will go through down cycles. We need to understand that if one or two major companies in an industrial sector is losing money, there's a good chance the whole sector is facing decline.
5. Inflation risk - The chance that inflation will be higher than our investment return, with an actual loss of buying power. That is why a 2% return in passbook savings really costs us money, with inflation over 3% each year.
6. Liquidity risk - If we buy a security, it goes up, and we are unable to sell to take our profit, its increase didn't do us much good. Thinly traded stocks are often hard to sell quickly and cancel any quick return. Particularly, this risk is high on penny stocks and junk bonds. We limit our stock picks to those with an average of over 50,000 shares traded daily.
7. Diversification risk - The old adage about having all eggs in one basket is as true today as ever. This means more than just investing in several stocks. They should be in diversified industries or sectors to avoid the cyclical risk above as well as events beyond our control. Disasters occur without considering our positions in the market. They occur without asking! The key is to mix it up. Spread the risk across a variety of stocks.

• Since mortgage interest is deductible, we may only be "earning" about 6% net, depending upon the age of the mortgage, how much interest we pay with each payment.
• An investment in an index fund might return 12% gross, with an after-tax net of around 8%.
• Therefore, the market play brings more than paying down the mortgage.

• Treasury Bills are considered "risk free" investments with a low return. We simply do not get returns higher than T-Bill rates without assuming substantial additional risk.
• Our mortgage rate for sure is higher than T-bill rates, so on an "apples to apples" comparison, paying off the mortgage first is a no-brainer.
• We get a risk free pay-off (the pay-down of the mortgage) at better than the current "risk free" return (a Treasury Bill rate).

This second view believes only "risk capital" belongs in the market. "When the house is paid for, and we have accumulated savings to cover emergencies, then we should get involved in the market."

Which of these two scenarios do you feel most comfortable with?

These two viewpoints represent two extremes. That is, we may feel some comfort level in-between, putting some of the cash into the market and the rest on the mortgage. Or, assessing spending in other areas, where we might find money in our budget to begin investing that won't put basic needs at risk. This is the kind of gauge we need to assess our personal risk tolerance as we enter the investment arena. We must each find the balance right for our own situation.

Everyone has his or her own risk tolerance and we should never make any investment that makes us feel uncomfortable. That is not to say we should not be concerned with our investments. There is a profound difference between "concern" and "distress." When I drive to work each day I am very concerned with the traffic, with using my rear-view mirrors, keeping a safe distance from the car ahead, and defensively watching for "crazies" doing something over which I have no control. But I do not lose any sleep the night before stressing over the upcoming drive. Similarly, with our investments we can "drive defensively" without distress, when we each find our own reward/risk balance.

Reviewing how this affects our decisions playing rolling stocks is informative. During the recent bull market we have been able to play rollers that were less than stellar in terms of fundamental performance. What this means is that our risk/reward balance will change with market conditions. In a bear market, we can still play stocks as rollers in the same manner.

However, with the market trend down, stocks with less substantial fundamentals will be less likely to turn up from an established support level. We study our picks carefully each week to find those that satisfy our criteria of good fundamentals and supportive technicals with good news. In a down-market, we must be less risk-tolerant to protect our positions.

In the drive to work, with bad weather, road-work, or an accident ahead, listening to Sky-chief helicopter traffic may alter the route we choose.

A most helpful graphic in understanding how we can react to this matter is what is called the Investment or Risk Pyramid. Any course of study dealing with investments will feature this graphic, primarily because of its simple nature in explaining the issues we all need to consider.

First, lets revisit a definition of risk as it applies to our current investment strategies. The most common definition is simply the risk we take that we might lose some or all of the money we invest. That's okay, but it fails to consider the opportunities or the lack thereof that are so meaningful today. A better definition would consider what is termed an absolutely risk-free investment as a benchmark reference.

How about, "risk is the chance we take that we'll earn less from an investment than the interest available from insured savings certificates or U.S. treasury notes." Or more simply, the chance that we'll earn less than 4% or 5% on our money. If we can't expect to do better than that, there is no reason to take the risk.

Given that definition, lets look at the Risk Pyramid as a visual to help reduce our risk. We begin with the pyramid divided into four levels, each level becoming smaller as it moves towards the top.

1. The bottom level has wide base of financial security:

• a home
• insured savings
• insurance to cover health, auto, home, disability
• cash

1. The next level, not as wide as the first, represents space available for some risk in our financial plan. Low-risk mutual funds are usually placed here along with low-risk dividend paying stocks. The greater the risk in an investment, the higher up it goes in the pyramid and accordingly, the less money we should put in it.
2. The higher we go, the more narrow the level. On the third step we have space in our portfolio that is available for investments involving more risk. The greater the risk of an investment, the higher up the pyramid it goes. And thus, the less money you should put into it. Real-estate investments are often placed on this level.
3. The top of the pyramid is for high-risk investments, the ones we are told not to get into: penny stocks, commodities, limited partnerships, etc.

For us, what is placed into each level is not nearly as important as the graphic itself. We must define for ourselves what we place into each level in our own pyramid. This does not mean we should avoid all high-risk investments. It means we must understand the risk/reward relationship we discussed earlier and keep the high risk stuff at the top of our pyramid.

As we generate income from our rolling stock strategies, we must remain balanced and keep salting a portion of our returns into our base. The road to success is like driving from New York to Los Angeles. If our goal is Los Angeles, there are a multitude of paths we can take. Each path will have its own personality, its joys, its difficulties. In the same way, our path to success can be as varied. Our particular set of strategies need not copy those of any one guru. We must find our own.

In previous sections we've discussed the nature of the risk we take with our stock market plays. I recently heard on the radio a commercial that said something like, "The Dow is up, the Dow is down. Isn't it about time you invested your money in a risk free money market account? Ours has consistently outperformed other money market accounts by "x" % over the past "y" years...." The implication was, of course, that the market is more risky than their money market. However, we considered one element of risk as "...the chance that we'll earn less than 4 or 5% on our money." If that is the stable return on a money-market account, we have no benefit from the risk taken. Unless! Unless that is the level of risk we can tolerate without losing sleep.

Before we leave this discussion on risk, lets take a self-exam on our own risk tolerance. The following is like exams found in the investment literature and will help us understand our own risk tolerance. In this exam we'll find questions that deal with facts (our age, our assets, our obligations) as well as how we react in various circumstances. Exercises like this will help us examine our comfort zones in making investment decisions.

Answer each question, keeping track of the score for each answer:

1. Years before you will retire:
1. 1 - 5 (0 points)
2. 5 - 10 (5 points)
3. 11 - 20 (10 points)
4. More than 20 (15 points)
2. Personal assets, home equity, bank accounts, CDs, stocks, mutual funds, bonds:
1. Less than $5,000 (0 points)
2. $5,001 to $10,000 (4 points)
3. $10,001 to $20,000 (6 points)
4. $20,001 to $50,000 (8 points)
5. More than $50,000 (10 points)
3. Will cash be needed from these accounts during the next five years?
1. Definitely (1 point)
2. Probably (4 points)
3. Might (6 points)
4. Probably not (8 points)
5. Definitely not (10 points)
4. You are on a TV game show and can choose one of the following. Which one would you choose?
1. $1,000 cash (0 points)
2. A 50% chance of winning $4,000 (3 points)
3. A 20% chance of winning $10,000 (5 points)
4. A 5% chance of winning $100,000 (10 points)
5. You've invested $1,000 in a new business venture started by an acquaintance. The concept still appears sound, but additional capital is needed to actually launch the business. How much money would you be willing to invest -- in addition to your $1,000 -- to have a chance to recover your initial investment and perhaps make a profit?
1. None. You'd accept your $1,000 loss and not put any more at risk (1 point)
2. $200 (2 points)
3. $500 (5 points)
4. $1,000 (8 points)
5. More than $1,000 (10 points)
6. A month after you buy a stock, it jumps 25% in price. Which would you do?
1. Sell now and take your profit. (0 points)
2. Hold it and hope it continues to increase. (3 points)
3. Buy more, expecting it to rise. (5 points)
7. You buy stock that drops 25% a few weeks later. You still believe the company is sound. What would you decide to do?
1. Buy additional shares at the new price. (5 points)
2. Hold the stock and wait for the price to recover. (3 points)
3. Sell immediately to cut losses short. (0 points)
8. Your annual salary increase is 5% of your pay. Your boss gives you the option of taking the raise now or being paid a bonus of 50% if the company makes its profit goal for the coming year. However, you won't get the raise or the bonus if the goal isn't met. Which would you take?
1. The certain 5% raise now. (0 points)
2. The chance for a 50% bonus. (5 points)

Maximum score for exam: 70 points.

The designers of this self-exam would rate you accordingly:

	Score		Risk Tolerance
	0 - 14		Extremely conservative
	15 - 28		Conservative
	29 - 42		Moderate
	43 - 56		Moderately aggressive
	57 - 70		Aggressive

Nothing about this exam is absolute. Our risk tolerance will change with our age, with our understanding of market fundamentals, with our changing economic position in our career path and with our increased obligations to family and other responsibilities. It is our position that the most important feature of balancing our personal risk tolerance with available resources is one of understanding. That is the mission of Pro-fundity.