Just about every investor wants safety, income, and growth, but is it possible to have all of these things at the same time? The short answer is no, but that’s not a bad thing.
When you fully understand risk and the role it plays in your investments, it can completely change the way you think about it. Furthermore, understanding your personal tolerance for risk can allow you to use risk in a way that aligns with (not undermines) your long-term financial goals.
Let’s take a look at what risk is when it comes to your investments and how you can leverage it as a tool to help achieve financial success.
What is financial risk?
To oversimplify, financial risk is the possibility of losing money. High risk is associated with the potential for big losses, but it often can also provide the potential for the highest reward as well.
Inversely, low risk aims to eliminate the potential for big losses, thereby also canceling out the possibility for large gains.
As an investor, you are either comfortable with risk, not comfortable with risk, or somewhere in between. This is commonly labeled as your risk tolerance, or how you feel about risk. Your risk capacity, on the other hand, is essentially a measure of how much risk (loss) you can afford without it literally devastating your financial well-being and future.
Related content: What Investors Need to Know About Risk
3 Ways Financial Risk is Helpful
Even though risk can seem scary, it can be a powerful tool within your investment strategy to help you reach your financial goals over the course of your lifetime.
When starting with new clients, we review the basics of risk, especially the risk reward trade off (i.e. you need to take some risk in order to have some possible gain). This is personal to each investor and there is no right or wrong answer per se, but there is usually a bad, neutral, good, better, and best answer depending on the impact and potential outcomes certain levels of risk can have on an investment portfolio.
Here is how appropriate levels of risk can be helpful:
1. Risk can yield higher returns. Higher returns almost always involve higher amounts of risk. You will never build wealth by keeping your cash saved in an FDIC-insured account (almost zero risk – zero reward). In fact, you will lose purchasing power as inflation erodes any small return. Luckily, there are ways to aim for higher potential returns by taking on more calculated (and not unnecessary) levels of risk.
Related content: Diversification: The Right Way to Manage Risk
2. Risk can keep you level-headed. Risk can serve as an effective speed bump on your path to financial success. Greed can get the best of all of us, and the potential for big reward can be alluring. I have seen many investors (often the same investor) get extremely risk tolerant during up markets and very risk averse during down markets. Risk is a welcomed consideration that causes investors to slow down and reassess. Investing for the long-term means you will continuously re-evaluate how much money you are willing (or able) to lose and whether or not you’re on track to reach your financial goals. The trade-off has to be aligned.
3. Risk can prevent you from making a mistake. The awareness and potential for loss can be sobering for your financial life. Aside from helping you to invest with a level-head, it can stop you in your tracks from making a huge, sometimes irreversible financial mistake. If you are two years from retirement, for instance, you are not going to invest all your savings into an up-and-comer start-up that could be the next Amazon or Apple.
Ultimately, every investor should look to achieve the highest amount of return with the least amount of risk. Your risk tolerance and capacity evolves as you advance through the decades, which is why your investments should evolve with you.
Remember, if it sounds too good to be true, it probably is. Risk isn’t a bad thing. In order to achieve your goals you will need to take risk, just makes sure it’s an appropriate level of risk that you can handle.
Questions about your own risk tolerance and if you are invested properly?
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