What is investment risk and how much risk should you assume? Simply stated, low risk investments are more stable, with a lower return on investment but more predictable activity. High risk investments can provide a much higher rate of return, but more likely to react with extreme highs and extreme lows, which includes an increased possibility of loss.
And not all investments are purely high or low, black or white. Varying degrees of moderate risk investments are also available. And, just as no single investment vehicle should be selected, no single risk level should be selected.
After you identify the proper risk level for the majority of your investments, also allocate some funds to both slightly higher and lower levels of risk. Diversify.
Your personal risk tolerance level needs to be identified before investing your first dollar. If you choose to seek professional investment guidance, all credible stock brokers or financial planners are aware of this. Their expert analysis will determine what your risk tolerance level is. Then they will work with you to find the investments best suited to your personal goals.
If you decide to not use a professional investment service, and do you homework first. It is especially important you understand how investment risk relates to your personal investment goals. Determining your risk tolerance is just one of several important factors which need to be examined and balanced.
First, consider how much money you have to invest, and also anticipate your future funding contributions. Plus, identify your target goal, exactly how much money will you need. Next, determine the time remaining to reach your goal. All these factors combined will greatly influence your investment risk decision.
Are you savings for your first home in five years, or possibly college education for your children? Or, like the largest group of investors, are you preparing for retirement?
For example, if you are in your early twenties or thirties and you want to start investing for your retirement, your risk tolerance can be higher, with a large percentage of your investment chosen from a high risk category. When your investment has periods of downward activity, you will have enough time to wait out market corrections. .
What if your time to reach that goal is more near future rather than long term? Examples would be move into that new home in five years or college education for your children in ten years. Then you may want to select mostly moderate risk investments.
If you are in your forties or fifties and investing for your retirement income, many serious factors need to be balanced. If you did start your investment program years earlier, you definitely want very low risk investment selections, and keep those funds as safe as possible. However, if you are getting a late start, you now have fewer years to reach your goal and will need a very different approach. As well as the need to diversify your investments to include some moderate levels of risk, you may also need to modify your goals. Consider investments with levels of return which are safely obtainable within your time frame.
Another important factor is the emotional factor, as to how you feel about risk. Again, this will have a major impact in determining your tolerance.
For instance, if you invested in the stock market and you watched the movement of that stock daily and saw that it was dropping slightly, what would you do?
Would you sell immediately, or would you watch your investment ride out the storm? If you have a low tolerance for risk, you would want to sell out. But if you have a high risk tolerance, you would let your money ride and see what happens. This is not based on what your financial goals are. This tolerance is based on how you feel about your money!
Again, a good financial planner or stock broker should help you determine the level of risk that you are comfortable with, and help you choose your investments accordingly.
Your risk tolerance should be based on what your financial goals, plus how you feel about the possibility of losing your money. All these factors are closely tied together. Then read and compare all you can about your selected investment, study the historical earning patterns and ratings, and years of operation. Become comfortable with your decision. If you do not feel completely secure in your own decision, definitely seek professional guidance.
What is risk tolerance? It’s your ability to deal with investment losses … usually in the short-run … to have the chance of earning higher long-term returns than you would get in a bank account.
?On the one hand it’s about how much you can afford to lose. ?On the other hand, it’s also about how much money you can emotionally tolerate losing.
It’s extremely important to your success as a long-term investor to know your tolerance for risk. It’s a key part of designing an investment program that is appropriate for you and for picking individual investments.
What You Can Afford to Lose: An examination of your individual circumstances is required to figure out how much of your nest egg you can afford to lose in the short-run on investments that promise to deliver attractive growth in the long-term. But there are some general guidelines:
?Generally speaking, the more years you have until retirement, the higher your risk tolerance should be.
?Conversely, the more likely you are to tap into your nest egg early, the lower your risk tolerance should be.
The Emotional Aspect of Dealing with Risk: Studies of investor behavior show that emotions are a significant contributor to poor, long-term investment performance. Investors tend to get stuck on an emotional roller coaster that leads to poor investment decisions. Here is what the roller coaster ride often looks like:
?Investors get excited about investments that have already gone up and buy near the peak in value. When prices drop, investors find it emotionally difficult to accept and will rationalize holding on until prices improve. Then the bottom drops out and investors sell near the bottom, no longer able to cope with the anguish. Emotionally battered, they find it difficult to reinvest near the bottom and end up missing the next move up … only to reinvest later on after values have risen above where they had sold (buy high … sell low?) Then values peak once again, prices drop and the cycle continues.
Sound like anyone you know? This is why sticking with a disciplined investment plan is so important to successful investing. Overcoming your natural emotional reactions driven by fear and greed is the key. But that is hard to do.
?It becomes harder the more risk you accept in your investment plan.
What Percentage of Your Nest Egg Can You Lose? Before designing an investment plan, it is helpful to think about your risk tolerance in terms of a percentage. For example, you might say “I am willing to see my portfolio decline as much as 12% for a period of time if it gives me the opportunity to realize better growth over the long-term compared with leaving the money in a risk-free bank account or CD."
?Perhaps you could tolerate losing as much as 30% of your nest egg temporarily investing in something you thought could earn you a long-term growth rate as high as 10% to 15% per year.
Build a Disciplined Plan Around Your Risk Tolerance: No matter whether you’re a big gambler or a scared chicken, knowing your risk tolerance expressed as a percentage should make it easier for you and/or a financial professional to design an investment program that isn’t likely to push your emotional hot buttons.
?If the inevitable volatility of your investments remains within your emotional limits, you will be miles ahead in the long run simply from having been able to stick with a disciplined strategy.
You and/or a financial advisor can compare your percentage risk tolerance to the historical volatility (annual standard deviation) of different types of investments and design portfolio allocations that will more likely meet your long term investment objectives while staying within your risk limits.
Calibrate a Mechanical Investment Strategy to Your Risk Limits: With the use of computers and mathematically-based investment strategies, it is now possible to calibrate a mechanical investment strategy to your maximum risk tolerance.
This is what we have done at ConfidentStrategies.com. We have Model Portfolio strategies calibrated for a maximum risk tolerance of 5%, 7%, 12% and 30%. Fortunately, you don’t need any financial or mathematical background to take advantage of these sophisticated models as the work is all done for you and presented in the easy-to-understand form of Model Portfolios.
Benefit From Higher Risk-Adjusted Returns: Our Model Portfolios have not only successfully managed volatility risk but increased longer term rates of return. The result has been very attractive “risk-adjusted returns" compared with more traditional investment strategies. “Getting well paid" for the risk you’re taking may seem like an obvious approach, but few other methods of investing allow you as much control over the relationship between risk and return as mechanical strategies such as ours. To learn more about our investment models for stock market and mutual fund investing subscribe to our free strategic investment newsletter at http://www.confidentstrategies.com.
Both Sadie Jane & Mark Kramer are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.
Sadie Jane has sinced written about articles on various topics from Investments, Marketing Tips and Site Promotion. SadieJane has been marketing online for some time now and is also the author of many articles on marketing, the internet, and investing.