If you had a choice, would you take on more risk if it meant more profit? Would you accept a lower profit for less risk? How much profit does it take to make it worth taking on extra risks? These are the questions that can only be answered by the individual taking on risks. Some people avoid risks, while others confront it head on. In this step of the strategic risk-management process, or SRMP, we need to figure out which kind of person you are.

Since every investment involves risk, it is important to know how risk tolerant we are. “Risk tolerance” is the amount of risk you are willing to take on to achieve an investment goal. You can have three different attitudes towards risk. Individuals who are afraid of, or highly dislike, taking risks are known as “risk averse.” These individuals will prefer an investment with a lower expected payoff if it has less risk. An individual is said to be “risk-neutral” if she cares only about the expected payoff of an investment and not the risk she has to take to achieve her investment goal. Such individuals will neither actively take risks nor pay to avoid them. An individual who actively engages in risky investments is referred to as “risk-seeking.”

You can see what your risk tolerance is with a simple example. Suppose you have just harvested your wheat. You have been offered $20,000 for the entire crop by your local elevator. If you store your wheat, you figure you have a 75 percent chance of the price being $26,000 and a 25 percent chance of a getting $10,000 if prices fall. The expected value of storage would then be $22,000 (.75 x 26,000 + .25 x 10,000). This presents a dilemma. Would you take on the risk of storage to gain a “risk premium” of $2,000 ($22,000 with risk versus $20,000 without it)? You would be better off with $2,000 in the long run, but getting $10,000 for your crop 25 percent of the time. Would it change your mind if the risk premium were $4,000 or $400?

The SRMP can help you determine your risk tolerance. One method involves filling out a questionnaire, which consists of a series of questions concerning different situations involving risk. Each answer has a score reflecting your risk tolerance and there is no right or wrong answer. At the end of the questionnaire, you will be asked to add up your score and told how risk averse you are. Another approach finds your risk premium by asking some questions about how you trade off risk and returns. By knowing your risk premium, you can determine whether an investment that makes less money and has less risk would be preferred to one that makes more money but with more risk.