Risk: How Much Can You Tolerate?

a man jumping out of a plane with a red sky diving outfit

When you first start to invest, one of the things mentioned is the term “risk”.  Your level of risk tolerance helps determine what kind of investor you are or will be.  Risk also has to do with how much you are willing to gain and lose.  In general, the more risk(s) you take the more you might gain or lose, so why take the risk at all?

Risk can mean different things to different people.  When it comes to investing over long periods of time, it’s important to understand the types of risk that are associated with different types of investments.  It’s also important to understand that by doing nothing other than keeping money in a bank account also subjects you to a type of risk: inflation risk.  When your investments don’t keep pace with the rate of inflation, you will lose purchasing power over time, and that in itself is a risk.

Here’s an overview of inflation risk and other common investment risks:

  • Inflation Risk:  This is the uncertainty over the future value of your investment and subsequent purchasing power, since inflation will undermine investment performance.  The performance of an investment, taking into account the effect of inflation, is referred to as the real return.
  • Market Risk:  This is the risk that the value of an investment will decrease due to changes in the financial markets, also know as its volatility.  In short, a highly volatile investment has greater risk that its value may go down significantly in the short term.  A low volatility investment has less risk of a significant drop in value.
  • Credit Risk:  This is more common for bonds.  It is the risk that the issuer may experience financial problems and is unable to pay periodic interest and/or may not return the principal amount at maturity.  Bond ratings measure credit risk.  Several private agencies, such as Moody’s and Standard & Poor’s, rate bonds based on their assessment of these underlying risks.
  • Interest Rate Risk:  This is the risk that the relative value of a security, especially a bond, will decrease due to an interest rate increase.  As interest rates rise, bond prices fall and vice versa.  Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders.
  • Other Common Risks:  Other risks include economic issues or international activities that may cause market investment values to fall.

Risk It & Win It

When you are young and have time to ride the ups and downs of the market, you can usually take more risks.  Why?  Because you probably have years ahead of you to build back your finances if the high risk takes a few bites out of your income.

Risk It & Lose It

When you near retirement and may need to use your investments for income, it’s probably not a good idea to take a lot of risk because you don’t have many ways to compensate if your high risk brings major dips in income.

For example, a young person in the workforce might have an allocation of 80% stocks and 20% bonds; whereas, a retiree might have the opposite – 80% in bonds and 20% in stocks.  Someone nearing or in retirement may choose to dial back on the percentage in stocks because stocks may produce a high return, but they can also result in huge losses.  A young investor would probably have more time to bounce back from high risk loss, but a retiree may not, especially since they could be depending on returns for income.

That said, some people are just bigger risk-takers than others.  We see it in investing and everyday life.  There’s the kind of person who will make the big bet and risk it all, and the person who avoids risk entirely.  Some people, even with years of life ahead of them, will not take the risk.  And that’s okay.

Assessing Your Risk Tolerance

Ultimately, you are the one investing.  Awareness of your personal risk tolerance helps you understand whether you are a conservative, moderate or aggressive investor.

A Money Coach can help you understand your options for completing a risk tolerance questionnaire and gaining a better understanding of your own tolerance for risk.  Balancing your comfort level of risk with your investment selection will make you a more confident investor!  Call a Money Coach today at 888-724-2326.