In a perfect world, all investments would pay enormous returns and guarantee minimal risk. But since we don’t live in a perfect world, our best bet lies in understanding the risk vs. reward problem.
Any investment carries a certain amount of risk; it’s just that some are riskier than others. Because the risk of losing your money is high, there is also a high probability good returns. It’s the “no pain, no gain” concept at play here. This is the main reason why most financial advisors emphasize the importance of risk tolerance.
Most financial advisors would also encourage investors to readjust their investment portfolio. This means optimizing it to ensure it’s getting the most it can for the level of risks you take. Rearranging your investment portfolio usually requires you to diversify the assets you hold. And once your portfolio is adjusted for efficiency, the only way to increase returns is to increase risks.
It’s also good to keep in mind that getting superior returns isn’t always up to you. Investing is synonymous with uncertainty. There is still a possibility that the company you’re investing in won’t perform well in the next quarter. (Yes, even if you’ve done the research).
While we can’t control everything, we can focus instead on managing uncertainty. As sensible investors know, high-risk investment can yield high returns. But these same investors also know the real possibility that they won’t get their money back. This is, after all, the essence of the word ‘risk.’
Managing uncertainty will bring you face-to-face with three common elements: losing your money, achieving your financial goals, and knowing your tolerance for risk.
The most common fear among new investors is the possibility of losing money. But there are options, depending on your risk tolerance. Among the most low-risk investments you can put your money into are U.S. Treasury bonds and bank certificates of deposit (CDs). While these types of investment ensure that you won’t lose your money, they only offer meager returns on investment. In fact, with these low-risk investments, you can expect very little growth especially after accounting for effects of inflation and the taxes.
The second type of risk is your financial goals. Managing uncertainty will include making calculated risks. and knowing your goals can help you strategize. Some of the factors you may want to consider when strategizing include the amount invested, length of time invested, the rate of return or growth, and fees, taxes, and inflation. Using these factors, you then need to figure out how much risk you can tolerate. If, for example, your risk tolerance is low, you can compensate for the lower anticipated return by increasing the amount of money and time invested.
For many investors, a modest amount of risk, such as the example above, is an acceptable way to achieve their financial goals. Diversifying their portfolio with investments of various degrees of risk also helps them take advantage of a rising market and protect themselves from massive losses in a down market.
The third factor you may want to look into is your personal appetite for risk. Every investor is different, which is why it’s crucial for you to figure out your comfort level. Then you will create an investment strategy based on your personality.
Determining your risk tolerance can be as simple as submitting every potential investment to the “good night’s sleep” test. A compatible investment means that the amount of risk in your portfolio won’t drive you to worry so much that you lose sleep.
While there is no prescribed amount of risk, it is universally believed that younger investors can afford more risk. Older investors should by theory not take on as much risk because they do not have as much time to recover if disaster strikes. Older investors are generally advised to avoid risking their nest egg because significant losses mean little time left to recoup.
The bottom line is that high risk means a high probability of huge returns, while low-risk investments attract little growth. It’s essential for every investor to find out their tolerance for risk. Create an investment strategy that will help you achieve your goals.