Investing involves risk. Each of us is unique, and understanding how much risk you can tolerate is fundamental to shaping your own investment strategy. During the Global Financial Crisis, so many people forgot about or did not understand their own unique risk tolerance to their peril. This is how we ended up with the travesty of Storm Financial convincing retirees, with no income, to borrow against their homes and invest into high risk investments on the stock market. Different investments have different risk characteristics. Understanding your risk tolerance, will help to decide which investments have the right fit for you.
So what is risk? I define risk, in the investment sense, as the likelihood of losing money. Be warned, strangely enough, many in my industry do not see it that way. Fund Managers, people who invest your money in a range of investments on your behalf, often see risk as the risk of underperforming the market. This means if they lose you 10% of your money but the market loses 20% they think that they have done a good job! Oh, thank you so much Mr Fund Manager for losing my money so well and charging me fees for it too! (I will write more on how they get away with this later). In my opinion, losing money is losing money, doing it better than anyone else is not the aim of investing.
So how do you figure out your risk tolerance? Given your ability to handle risk is entirely unique to you, there are a range of factors you should think about in deciding how much risk you can handle including:
- Your Age – generally speaking the younger you are the more risk you can afford to take as you have more time to ride out any fluctuations in markets and make up for any mistakes.
- Your Goals – what are you investing for? If you are investing for your retirement, depending on your age, the long term nature of the goal means that you could afford to take more risk than if you were planning for a holiday in a year’s time (short term goal). When my husband and I were saving for our house we were invested in markets for the first few years but then as we started to get serious about purchasing we put the majority of our deposit into cash. Yes, we missed out on some returns (we brought our house pre GFC), but for us given that we thought a purchase was imminent, it became more about preserving our deposit than making extra money.
- Your Circumstances – this includes things like are you thinking of having a baby? How stable is your job? How good is your health? How secure are your current financial circumstances?
- Your Personality – how risk averse are you in your daily life?
Another clue to your risk tolerance is to think about how you would feel if the value of an investment dropped by 20% overnight. As all parents know, you should avoid losing sleep at all costs! If such a scenario would cause you to lose sleep then it is likely that high risk investments are not for you.
Like everything risk tolerance is a spectrum and it is crucial to remember that your risk profile changes over time. The risks I could take in my twenties when I was single, are different to what I can take now that I am married with a child and this will be different again as I approach retirement, which thankfully is still a fair distance away!
Understanding your own risk tolerance is key to making sure each investment you make is right for you.
Next on our investing journey we are going to look at the fundamental relationship between risk and return. Many investors get scammed as they fail to understand this essential rule of investing, then we will look at the risk characteristics of broad investment groups so you can see how they relate to your risk tolerance.
If you liked this post check out the rest of the series by clicking on the links below: