A crucial factor in successful investing is understanding risk and how much of it you can afford to take.
All investments involve a certain degree of risk. Whether you’re buying a government bond or shares in a start-up company, you are lending money. In some cases it’s very unlikely you won’t be paid back, but you also won’t get much return for the risk you’re taking. If you’re willing to take more risk, you’ll be offered a better potential return.
What is your Risk Tolerance?
In some ways risk tolerance is very personal and emotional. How nervous do you get when you think about losing money? How would you react if the value of your investments started to drop?
There are two potential dangers here:
1. You’re too comfortable with risk and end up taking on more than you can really afford.
2. You’re so afraid of risk that you aren’t willing to take the risks necessary to get the return you need.
There are also objective factors that go into understanding your risk tolerance:
What is your timeframe? (Or “time horizon” as the investment industry likes to put it.) If you’re saving to buy a new home in the next three years, then you will probably want to keep your savings in fairly conservative investments so the money will be available when you’re ready. If you’re saving for retirement, 35 years from now, you may want to consider taking on more risk. You’ll potentially get a better return, but there’s also time to recover from any market drops. But if retirement is only a few years away, you should probably cut down on your risk so you won’t have reduced savings just as you’re ready to start withdrawing income.
How much can you afford to invest? If you’re earning a good income, without high living expenses, then it could make sense to put some of your savings into higher risk investments that may earn better returns. But if the money you’re putting into savings is difficult to spare, then perhaps you should stick to lower-risk investments.
Should you ignore your feelings about risk?
Unfortunately, there are times when you may have to accept more risk than you’d like:
• When the market drops, our instinct may be to sell out as fast as possible. But this could be the worst choice, since the historical evidence is that markets recover. By selling you would be locking in your losses.
• It may feel more comfortable to stick to very low- risk investments. But you must also understand the possible consequences. When the time comes to spend the money you’ve saved, you may have to settle for less than you want because your savings haven’t earned enough return. In addition, inflation may have eaten away the value of your savings.
The balancing act:
Risk tolerance is a balancing act between your emotions and your practical concerns. Often compromise and a little better understanding of how your investments work can help you achieve your goals while still sleeping at night.
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