Stocks, savings, safe: Which is the most risky?

By Jennifer Rose Hale

The debt-ceiling crisis, besides delivering a healthy dose of politicians behaving badly, had another side effect. The Associated Press reported that stockholders were selling stocks at higher rates than normal, preparing for the possibly devastating effect the crisis would have on the U.S. stock markets.

This isn't the first national or world event that spawned a big stock sell-off. Catastrophes and shaky world events tend to spur a flight response even in experienced investors.

So, when a crisis hits, what makes you choose to either hang on tight or sell, sell, sell? It's called "risk tolerance"--your own personal willingness to take a chance with your investments.

What is risk tolerance?

Your tolerance for risk is determined by how comfortable you are with the possibility of losing your money. It seems like a ridiculous concept: How comfortable are any of us with losing money?

But we're not talking about a $20 bill missing your pocket as you walk away from the ATM. When the stock market crashed in 2008, stock market investors saw their balances drop 20 percent, 30 percent or even 40 percent. BusinessWeek reported that the average 401(k) investor lost 24.3 percent of the account's value.

So, for an easy definition, your risk tolerance is exactly what your gut told you when you saw your $10,000 retirement fund drop to $7,570 over the course of a few weeks. For those with a low risk tolerance, this set off the panicked "Sell, sell--SELL!" reaction. If your tolerance is higher, you may have sighed philosophically and flipped over to "Lost."

Why take the risk?

So, why do people risk their money? In the world of financial management, willingness to risk loss goes hand in hand with the potential for bigger returns on your investments.

Consider the average rate of return for the U.S. stock market, a high-risk location for your money. Although it's weathered storms the last few years, the stock market has averaged an annual gain of 9.8 percent between 1926 and 2010, according to CNNMoney.

On the flip side, a low-risk place for your dollars--a savings account--earns a smaller percentage. The best online savings account rates may earn you just over 1 percent in 2011.

'Safe as houses': Which money should you keep close?

Financial advisers generally agree that the best place for your emergency savings is a savings account. While it may be tempting to put a large sum of money in a higher-risk investment, Suze Orman provided this guidance in her column in O, The Oprah Magazine:

"You just can't count on the market in the short term: Say you had $20,000 in emergency savings on January 1, 2008, and you put that money into a stock market index fund. Then, on December 31, 2008, you were laid off. You might have told yourself you'd be okay with your severance and your savings. But when you checked your account, you'd have found that its value had fallen to $12,600, since the S&P 500 stock index fund was down 37 percent."

Money tucked into an FDIC-insured deposit account such as a savings or money market account won't lose its value.

Also, liquidity and accessibility--your ability to get your money--are key. Be sure your emergency savings are available when you need them--either at a local bank or an online bank that can transfer your money with a few taps on the keyboard. Transferring money from a brokerage account can take more time--time you may not have in an emergency.

When should you chance it?

On the flip side, if you don't need your money for a while--years down the road--you may be willing to take a bigger risk with it. "The Wealthy Barber," a classic and readable work of financial advice aimed at young people, advocates for tucking 10 percent into a mutual fund to build wealth. But, like many other experts, author David Chilton notes that this is only a good strategy if the investment isn't needed for seven to 10 years or more. Your retirement savings, for example, can benefit from the magic of compound interest over years of investing.

For most people, smart money management will include both low-risk tools such as savings accounts and money market accounts and higher-risk tools like 401(k)s and other investments. How close you get your personal money profile to your risk tolerance will determine how well you sleep at night in these turbulent times.

In the end, your risk tolerance is defined by your situation … and your gut.