You might be familiar with the risk-reward concept, which states that
the higher the risk of a particular investment, the higher the possible return. But, many investors do not understand how to determine the level of risk their individual portfolios should bear. This article provides a general framework that any investor can use to assess his or her personal level of risk and how this level relates to different investments.
Risk-Reward Concept
Anytime you invest money into something there is a risk, whether large or small, that you might not get your money back. In turn, you expect a return, which compensates you for bearing this risk. In theory the higher the risk, the more you should receive for holding the investment, and the lower the risk, the less you should receive.
Located on the upper portion of this chart are investments that offer investors a higher potential for above-average returns, but this potential comes with a higher risk of below-average returns. On the lower portion are much safer investments, but these investments have a lower potential for high returns.
Determining Your Risk Preference
With so many different types of investments to choose from, how does an investor determine how much risk he or she can handle? Every individual is different, and it's hard to create a steadfast model applicable to everyone, but here are two important things you should consider when deciding how much risk to take:
- Time Horizon Before you make any investment, you should always determine the amount of time you have to keep your money invested. If you have $20,000 to invest today but need it in one year for a down payment on a new house, investing the money in higher-risk stocks is not the best strategy. The riskier an investment is, the greater its volatility or price fluctuations, so if your time horizon is relatively short, you may be forced to sell your securities at a significant a loss.
With a longer time horizon, investors have more time to recoup any possible losses and are therefore theoretically be more tolerant of higher risks. For example, if that $20,000 is meant for a lakeside cottage that you are planning to buy in ten years, you can invest the money into higher-risk stocks because there is be more time available to recover any losses and less likelihood of being forced to sell out of the position too early.
- Bankroll
Determining the amount of money you can stand to lose is another important factor of figuring out your risk tolerance. This might not be the most optimistic method of investing; however, it is the most realistic. By investing only money that you can afford to lose or afford to have tied up for some period of time, you won't be pressured to sell off any investments because of panic or liquidity issues.
The more money you have, the more risk you are able to take and vice versa. Compare, for instance, a person who has a net worth of $50,000 to another person who has a net worth of $5,000,000. If both invest $25,000 of their net worth into securities, the person with the lower net worth will be more affected by a decline than the person with the higher net worth. Furthermore, if the investors face a liquidity issue and require cash immediately, the first investor will have to sell off the investment while the second investor can use his or her other funds.
Sources of article:
Investopedia
