Here’s a typical question a financial advisor will ask to determine an investor’s risk tolerance in order to set up an appropriate strategy.
I respond to fluctuations in my investments in the following manner:
- I will sell quickly any time my investment loses value.
- Day-to-day market movements make me uncomfortable and if my investment loses value I am likely to sell it and look for a better alternative.
- I realize that markets may rise and fall randomly and I will watch my investment for at least a year before making changes.
- I believe that a long-term investment strategy will maximize potential returns and even if poor market conditions resulted in losses in a given year, I will stay invested.
In my experience, some people are afraid of any loss, while others discover their tolerance for risk is a lot lower than stated, or expected, and day-to-day fluctuations make their stomach churn.
Experiencing an investing loss also often alters a person’s risk tolerance.
Why take risks with your investments?
There’s the possibility that you may lose all or part of your investment in exchange for the possibility of a profit. Among others, some common investment risks are:
- With an insured bank investment you face inflation risk (loss of future purchasing power).
- With stocks/mutual funds/ETFs you face the risk that you might lose money if you sell after the value falls below your purchase price.
- With real estate and collectibles there is a risk that you may not be able to sell when you want, for the price you want.
Just because you take investment risks doesn’t mean you can’t exert some control over what happens to your money.
Related: Give Your Money Time To Grow
If you know the types of investment risk you might face then you can make choices about those you are willing to take and build a diversified portfolio with quality investments that can offset potential problems.
Assessing Investment risk
Each asset class poses their own particular risks.
- How do you figure out what the investment risks might be?
- Which ones are you willing to take?
- Which are never worth taking?
- What risks are you comfortable taking at any particular point in time?
A lot depends on your goals and personality. Your attitude can change over time with age, responsibilities and education.
Age is often an important issue. Conventional wisdom states that the younger you are, the more investment risk you can afford to take. But be careful about blindly following this rule of thumb. There are many variables.
A person who is the primary source of support for a number of people – with young kids and a large mortgage, for example – may want to take less risk than someone who is just responsible for him or herself.
Often an RRSP is a young person’s only investment. Yes, there are many years before retirement, but what if funds are withdrawn to take advantage of the Homebuyers’ Plan, or Life Long Learning Plan, or even to cover a sudden and prolonged job loss or other emergency?
Similarly, when someone is closer to retirement they might want to move some assets to income producers, but just because you’re 65 doesn’t mean you must shift everything to more conservative investments.
The larger a person’s investment base, the more willing they may be to take on added risk with a portion of their portfolio. Income and future earnings capacity also have a role.
Many people find that the more clearly they understand how various investments work, the more comfortable they feel.
Some investors make the mistake of assuming a high level of risk by looking for winners. By investing in something that’s receiving a lot of media attention they may be buying at the market peak and setting themselves up for future losses.
Fearfully selling in a sudden market downturn locks in losses.
Buying and selling too frequently increases trading costs and reduces your portfolio balance unnecessarily.
We increase our risks when we don’t monitor the performance of our portfolio in order to make appropriate changes, such as selling a loser and using the money for another investment.
Those close to retirement age with meager assets should resist the urge to adopt an inappropriately risky portfolio in order to build up their funds in a short period of time.
Investing to minimize risk
We often associate risk with losing money, but no investment is without risk. Investing too conservatively can be just as damaging as investing too aggressively.
You may need to adjust to accepting more risk in order to meet your financial goals.
Look at the big picture. When you choose new investments, do it with an eye to what you already own.
How does the new investment fit in with regard to your asset allocation and diversification? If the possible consequences are unacceptable to you, it’s better not to take them.
Most investors are interested in minimizing risk while realizing a satisfactory return. Smart investing involves risk management.