5 Step Guide to Understanding Investment Risk

Understanding Investment Risk

Photo Credit: StockMonkeys.com

Investing money isn’t all about sitting back and waiting for plump returns. Risk is a key factor, and the level of risk an investor is willing to live with determines their potential for large rewards – and also for large losses. Understanding exactly what risk entails should be the first task of any would-be investor.  Here are five steps that can help you understand investment risk, what your tolerance for it is, and a way to plan for it.

 

Step 1. Know Your Attitude Towards Investment Risk

An individual’s appetite for risk is known as their risk tolerance.  Those who are willing to make high-risk investments should be financially able to absorb losses. Those that have less money to invest should opt for low-risk investments.  In the most basic case, think of it this way – you’re playing roulette and you have three options – red, black, or green.  The odds of red are 49%, the odds of black are 49%, and the odds of green are 2%.  Where would you put your money?  How much money would you feel comfortable losing?  Would you diversify and put bets on multiple colors?  What if you knew that you’d get 100% of your bet on red or black, but if it hit green, you’d get a 1,000% return?  Would that change how you wager?

These are all things to consider when you invest.  You always have the potential to lose money, but luckily, there are a lot more factors in play compared to my simple roulette example.  You just have to remember that you’re investing in a company, and whatever the company does, your investment will mimic.  If it does well, usually your investment goes up.  If it does poorly, your investment will go down.  Are you comfortable with that?

 

Step 2. Assess the Asset Classes

There are four main asset classes, each of which carries its own level of risk. Allocating funds to these different classes is known as risk budgeting.

Cash: Cash is the least risky class, but consequently delivers the lowest returns. Those that make cash investments run no risk of losing any actual money, though the spending power of the money could fall if the interest rate is lower than inflation. Types of cash investment include cash ISAs, savings accounts, National Savings & Investments (NS&I), and money market funds.

Bonds: Government bonds, corporate bonds and gilts offer greater returns than cash but are more risky. In effect, they involve lending money to governments or corporations, who then pay interest on the loan until it is repaid. Some people believe that bonds can’t lose value, but if you invest in a bond fund, you may lose value on your investment.

Hard Assets: Investing in property such as offices, warehouses and residential property can provide good returns in the form of rental income and increases in overall property value. Conversely, falls in property prices can lead to large losses.

Equities: Equities refer to stocks and shares. These are the most risky class as the stock markets are notoriously unpredictable. Nevertheless, investing in UK equities is viewed as being less risky than US equities or those from emerging markets.

Investing Risk

Photo Credit: StockMonkeys.com

 

Step 3. Realize Time Risks

History has shown that investments in equity-based assets are the best way to achieve growth that outstrips inflation.  However, that history is also based on a long time period.  If you invest today, you need to understand that your investment may lose value immediately.  That is why short-term investors are advised to not take much capital risk.  However, those who invest over the long-term are better positioned to make riskier investments. This is because their money has longer to recover from any damaging market fluctuations.

Time is your ally when it comes to investment risk.  That is why if you need to money, you should stick to safe asset classes like cash, so that it won’t lose value and you can access it immediately if you need to.  As your time horizon increases, you can shift into riskier assets which typically provide a better return over time.  Then, as you get closer to retirement and needing access to the value of your investments, you can start shifting back into safer assets that are more stable in price.

 

Step 4. Set Targets

Now that you have a basic understanding of investment risk, you can set risk targets and other goals.  Setting investment goals will help you keep focused.  Decide what returns you would like to receive and by when.  Remember, you can go riskier, but you risk bigger losses.  You can go conservative, but your returns won’t be as high.  Many investment companies categorize your risk target as either conservative, moderate, or risky.

Once you’ve set your targets, monitor your investments to ensure that these goals are met.  Remember, since asset values fluctuate over time, you may find yourself having a different portfolio after a year, and that is why you need to monitor and rebalance as needed so that you are continually meeting your risk targets.

 

Step 5. Create a Balanced Portfolio

Most investors spread their money across asset classes. This allows them to take risks with money they don’t need for perhaps ten years, while placing the rest in low-risk assets.

Diversification and balance is key to mitigating investment risk.  You don’t need to put everything in cash, and likewise, you don’t need to be fully invested in stocks.  In fact, finding the right balance has historically been the best way to invest.  Keep a slice of your portfolio in each asset class so that you can take advantage of both higher returns and safety of capital preservation.

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Comments

  1. says

    I find that looking for dividend paying stocks helps me mitigate my risk in the stock market.
    Dividend paying stocks generally tend to generate large amounts of cash and have balance sheets that are in fairly solid position which is what allows them to pay dividend. That gives me great comfort that I avoid the biggest risk associated with any investment which is total loss of capital (ie company bankruptcy).

    A steady income stream from my underlying investment also helps you avoid a less common (and less appreciated) investment risk which is the opportunity cost of selling an investment too soon and not maximizing your return. By being focussed on the underlying income stream generated from my investments, I avoid the temptation to “lock in” some gains if my stock has increased 10-20%, because I look forward to the underlying income stream a stock generates. Being committed for the long run helps you really compound your net worth, and dividend paying stocks allow you to maintain that focus.

  2. says

    One strategy I was recently reading about that I really enjoyed was utilizing strategic dividend income to pay debt. I read a first hand story about an investor who purchased stock of his home energy provider, cable tv provider, cell phone provider and healthcare. Over time and strategically reinvesting certain times+special dividends, he is now able to collect the dividends and use the money to IN FULL pay his bills from the respective companies. The companies are effectively paying their own bills! Brilliant!

  3. says

    Great write up Robert! I find often times many investors don’t fully understand being diversified or having a handle on what risk they’re comfortable with. Many think that if they’re in a few stocks then they are diversified. It does generally take quite a bit more than that in order to be successful.

  4. says

    It’s interesting to look at the correlation between these asset classes. Example: while gold has three times the volatility of the stock market, because it performs differently than stocks, it can calm the top line of a stock-heavy portfolio. It’s like a little pepper on the chili to bring out the flavor!

    Thanks for the great read.

  5. says

    You’ve hit the nail on the head – proper allocation of capital is just as important, if not more important that the specific investments themselves. It’s important to look at your portfolio as a whole at least annually and to reallocate based on the shifts in weightings due to performance/underperformance.

  6. says

    I just had some financial advisors review my 401k investments, and this is the steps they took me through before making investment suggestions. Apparently, I’m have a very high threshold for risky investments, because I don’t care if the market swings down and up and down. :) I just want the best long-term return.

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