Risk is an integral part of investing. No discussion of returns or performance is meaningful without at least some mention of the risk involved. The trouble for new investors, is identifying where risk lies and how to calculate how much risk to take.
What Is Risk?
The term “risk” in general means different things to different people. For some, it’s something they want to avoid all together. For many, it’s a natural part of life that they try to find balance with (not too much, not too little). Others see risk as an exciting opportunity.
Risk in investing is not much different than taking risks elsewhere in life. It is essentially any form of uncertainty with respect to your investments that has the potential to negatively affect your financial welfare. No matter where you invest your money, there will be some risk. Since we cannot see the future, there is simply no way to avoid or eliminate risk if you want to be an investor, not even by having cash in the bank (inflation risk) . But you can learn to minimize and manage risk well.
How much risk is too much risk?
As fundamental as risk is to investing, many new investors think that there is a well-defined and quantifiable way to calculate how much risk is involved with a given investment. Unfortunately, there is not, but there are a lot of different ways to manage and deal with risk. Some investors like to pay close attention to market volatility (a concept used in stocks and bonds to determine the number of possible outcomes). Others like to keep a diversified portfolio that can counterbalance risks between different asset classes. Some will purchase various types of asset insurance. But choosing the right level of risk mainly involves understanding your ability to take on risk (your risk tolerance) and your willingness to take more or less risk than is theoretically right for you, i.e. your attitude to risk (or risk preference). Your attitude to risk generally determines the type of investments you will choose to invest in.
There are a number of factors that will affect your attitude to risk:
Your goals. Having goals is so important in investing because it’s difficult to make decisions without a clear vision of where you want to go. Are you saving for retirement? For a home? A kid's college fund? This will determine how risky you want to be with your money. Knowing your goals will help you measure how much risk you can absorb from a particular investment without compromising the achievement of the ultimate goal.
Your age (or “investment horizon” as some call it). Your age is an important metric to understand how much risk you should take. According to investors and experts, the younger you are, generally, the more investing risks you can take because you have a long investment period ahead of you, which means you are able to absorb short-term ups and downs.
Your income and future earning capacity. Generally, the higher your income, the greater your ability to cope with risk and respond to events.
Your knowledge and experience. The more experience you have with investing, as well as the more knowledge you attain in a particular asset class, the more prepared you are to understand risks associated with a given investment and how to cope with the consequences.
Your personality. People naturally respond to risk in various ways. If your personality leads you to worry whenever risk is present, a low-risk investment strategy may be best. On the other hand, if taking risks excites you then you’ll be more comfortable with an aggressive investment strategy.
In the end, the best way to decide if a risk is too high, is to picture what it would be like to face the worst-case-scenario consequences. If the consequence of an event happening is unacceptable, it is best reduce your risk. On the other hand, recognizing that risk can be well managed and present the opportunity to make great investments is necessary to achieving wealth through investing.
Would you be interested to find out more? Check our YouTube video, get in touch and one of our advisors would be happy to help.