How To Define Your Risk Tolerance
The amount of risk you’re willing to take has a big influence on the type of investments that suit your needs. But how do you define your risk tolerance? Let’s find out.
There are two major factors that you will need to take into account when looking at risk. Firstly, your ability to take risks. How much can you afford to lose if everything goes wrong? You’ll need to examine different elements of your financial situation and your lifestyle to make an informed decision about this. Next up is your willingness to take risks. How much capital are you able to put on the line without facing sleepless nights? A few different factors, such as experience, insight and your personal needs, will be influential.
This chapter helps you to better understand and define both your ability and your willingness to take risks. After doing so, you’ll be ready to determine your risk tolerance and take another step towards deciding how much capital you can comfortably invest.
4.1 Risk And Reward
What is investment risk?
Every investment you make has risk attached to it. In the investment world, this risk gauges the likelihood of an investment depreciating or, even going bankrupt. Whenever an asset defaults, you’ll inevitably lose any capital you have invested in it. As such, it’s vitally important to know the risk levels of anything you’re considering investing in.
The obvious solution would be to invest in low-risk investments. But low-risk investments have a downside; they returns tend to be lower. You can invest in them, but you’re not likely to earn massive amounts of money on them.
As the level of risk rises, the potential returns rise too. The investments that offer the highest potential returns are the investments that are most at risk of defaulting. There is a very good chance that they will prove successful. But is this a chance you’re prepared to take?
There’s no need to answer that question just yet. In fact, before you answer it, it’s probably a good idea to increase your understanding of the different types of risk.
Unsystematic risk is basically a type of risk that is unique to a particular company. It includes risks such as the workforce for the company going on strike. Without a workforce, productivity would obviously drop, meaning financial turnover would drop, clients would possibly move away, meaning financial turnover would drop even further and the share prices would plummet. It also includes unfavourable changes to legislation. These changes could affect production practices, the demand or availability of specific products or any one of a million other factors. Natural catastrophes also fall under unsystematic risk.
The good news about unsystematic risk? By investing in several companies, this risk is mitigated.
This is the risk that affects an entire market or a specific asset class. It could apply to a specific industry, a certain country or even the global economy. One example would be an industry becoming redundant or collapsing. Think of the effects of digital photography on the photographic film industry. Another example revolves around an inevitable lack of resources: how will the oil and petroleum industry respond when oil reserves run out?
Systematic risk also relates to external influences. Failure of one player within an industry can create a domino effect. If one bank goes bankrupt while owing money to other banks, those other banks could be financially crippled by the loss. If the supplier for Company A stops doing business, Company A cannot fulfil its contracts with Company B and Company C. In return, Company B and Company C find themselves in trouble, as do all the other companies and markets that relied on them.
It is not possible to mitigate systematic risk through diversification when the diversification is made within the same industry.
How do you avoid risk?
It’s no easy task. After all, there’s risk associated with every investment. However, it’s possible to reduce it by being careful about how you invest your money.
Diversification is one strategy. Instead of investing in just one industry, market, commodity or company, you invest in a larger range to ensure the bad luck that strikes down one of your investments is not likely to affect any other investments in your portfolio. (Diversification is examined in more detail throughout the guide, but particularly in Chapter 7 about building your investment portfolio.)
A lot of investors also choose to invest in a mix of low-risk and high-risk investments. This means that they have the opportunity to benefit from the high-return, high-risk investments, but they still have low-risk investments to create a median level of risk and return across their portfolios.
It’s also worth noting that there are investors who don’t necessarily avoid risk. Young investors often have the ability to face the consequences of failed high-risk investments; if they lose their investment capital, they have a few decades to overcome the setback, which makes the risk worth taking.
They reduce their risk over time by investing in more low-risk investments, especially as they approach retirement. It’s an interesting approach. But it means you need to know which investments qualify as having low and high levels of risk associated with them.
4.2 Low-risk Investments
Why invest in low-risk investments?
Low-risk investments have a more attractive risk/return ratio than their high-risk counterparts. It is possible to invest in low-risk investments and nothing else. As the returns are usually not as high, most investors create a portfolio combining both low-risk and high-risk investments.
If you compare low-risk investments with high-risk investments, you’ll typically find the low-risk investments offer better returns over time. You’re less likely to have your investment default and as such, you’re less likely to lose everything. They are excellent assets for adding diversification to your portfolio.
Besides this, low-risk investments are a great way for preserving the value of your capital. The aim doesn’t need to be to increase value over time, but to maintain existing value. The low risk appeals to many investors. If you don’t want to risk your hard-earned cash, make sure a larger percentage of your portfolio is invested in low-risk assets. Be patient. Over time, perhaps a very long time, your low-risk investments will hopefully pay off.
There are a number of different low-risk investments to be aware of.
A bank savings account
Probably the simplest and lowest risk investment possible is to leave money in a savings account. The problem is that interest rates are incredibly low. The various fees, inflation and other influences may mean you actually lose money.
Fixed-rate savings bonds
This does what the name suggests: a fixed-rate savings bond gives you a fixed rate of interest for the duration of the savings bond. Depending on the specific bond, the interest may be paid out every year or just on the date of maturity. As for the initial investment? You’ll have to wait until the date of maturity to get that back too. The duration of a bond varies, but most bonds are for five years. They are an excellent low-risk alternative.
Money-market securities are fixed-income securities. They include Certificates of Deposits (CDs), Treasury Bills, Commercial Papers (CP) and Letters of Credit. When you invest in one, you don’t need to wave goodbye to your investment capital for long: most money-market securities mature after one year, but sometimes, they take even less than a year.
When you combine this short maturation term with high-liquidity and high-credit ratings, you have one of the safest fixed-income securities available. There’s just one problem: most money-market securities are only available to institutional investors. The good news? There’s a way around this. Money-market mutual funds combine investments from a number of investors and place them in a range of different money-market securities.
Money-market ETFs work in a similar way to money-market funds. The difference is that ETFs are traded on a stock exchange and they also have something that’s always welcome: lower fees. Money-market investments are extremely low-risk investments. They generate low returns. But over time? Low returns add up. And since they have virtually no risk, they are always considered to be an excellent long-term investment.
Government bonds are also considered to be among the safest investments. At least they are when they’re issued by the governments of developed countries such as the USA, the UK or France. There are other countries with more volatile political situations and dubious credit records that issue bonds, but these have quite a lot more risk attached to them.
When you purchase a government bond, you’re basically loaning money to a government. You also charge the government interest. Unfortunately, it’s not very much; interest rates aren’t so high on government bonds. Nonetheless, they are reliable investments for the short, medium and long term. And charging the government interest? What a satisfying thought!
What’s the difference between government bonds and municipal bonds? Municipal bonds are issued by local, city, state or council authorities rather than federal ones. They usually offer slightly higher interest than government bonds, but at the same time, they’re also considered to be a touch riskier.
Multinational corporations are allowed to issue bonds too. The bonds allow them to bring in money to expand operations, acquire other businesses or fund new projects without having to sell extra shares or any other interests owned by the company.
When you invest in corporate bonds, you may be given the option of sub-investment-grade bonds and investment-grade bonds. The sub-investment-grade bonds are often considered to be high-risk junk bonds. But investment-grade corporate bonds? They’re far more reliable. The interest rates are usually slightly higher than what government bonds offer, but they have more risk attached to them too.
Remember inflation? It’s what makes everything more expensive. Or, if you prefer, it’s what makes your money less valuable. Inflation is the reason why, if you sold your home for €200,000 fifteen years ago, you probably wouldn’t be able to buy it back for the same €200,000 today. Inflation is also the reason you may be interested in an inflation-protected bond.
Inflation-protected bonds adjust the coupon payments and the principal value of the bond to acknowledge the rate of inflation. When you purchase the bond, inflation is set at 1%. This means the coupon payments are going to be 1%. After the first year, inflation increases by two percentage points, from 1%, to 3% interest. This means the coupon payments will rise to 3%. If inflation increases by another four percentage points, to 7%, you’ll receive 7% interest on the coupon payments. If the inflation rate is 0.05%, you’ll receive this interest rate on your coupon payments.
Bond funds collect a mixture of government and corporate bonds. Every fund is different. The trick to finding a safe, low-risk fund is to check that it only includes investment-grade, fixed-income securities. Once you’ve invested in a bond fund, all the investment decisions are made by a bond manager. Just remember that where there’s a manager, there’s also a substantial set of fees. Always check the fee structure of a bond before you invest.
ETFs are Exchange Traded Funds. They use the long-term performance of an asset to gauge its reliability. Which assets are these? Usually ETFs usually work with different stocks on the stock market. But not bond-ETFs. Instead of stocks on the stock market, they invest principle in a range of different bonds. There will usually be a portfolio of different bonds in any bond-ETF. The bonds could be a range of high-yield bonds, short-term bonds and long-term bonds from a variety of issuers including banks, government agencies and possibly companies.
High-dividend defensive companies
You’ll need to know what a defensive company is to understand this one. But don’t worry, it’s quite simple. Basically, they are companies with assets that have fairly minimal upturns and downturns in their values; they produce things that people need all the time. Gas, water, electricity and other utilities, food, beverages and even tobacco are all considered to be defensive. And this leaves just one question: why are these companies called defensive companies? When the stock market is volatile, investors put their money in these companies as a form of defence. It’s a pretty good sign that they’re safe investments.
A high-dividend defensive company pays out dividends from the value of stock every year. Sometimes even twice a year. This means you have security and regular payments. Nice!
When small businesses need money, they have the option of lending it from a bank, or another traditional financial intermediary, and paying fees, high interest rates and so forth. This isn’t always the best option. In fact, it might not even be a feasible option; a bank has the right to refuse a loan. As such, the business might head to a peer-to-peer lending platform. This allows the business to borrow money from private investors. The private investors receive fixed interest returns.
Is it risky? Of course! Remember: every investment has risk. But peer-to-peer lending has actually shown a low default rate. This rate has been developed over a relatively short lifespan and may not be the most convincing information. The good news is that most peer-to-peer platforms have ratings. Look for a peer-to-peer platform that has a high rating and that allows you to choose your risk/return category.
4.3 High-risk Investments
At the other end of the spectrum, you’ll find the high-risk investments. Although they all have a high risk in general, they still have different levels of risk. The risk is sometimes so high that there’s more likelihood of defaulting than there is of returns. But those returns, if they do come, will probably be very impressive … It’s usually a good idea to build only a small amount of your investment portfolio out of high-risk investments.
Microcap stocks have market capitalisation between 50 million USD and 300 million USD. They are illiquid. There are usually a few large investors who dominate the market for a particular microcap stock. This makes it very difficult to determine how the stock price will perform. The returns can be very high if you choose the right microcap stocks.
Penny stocks are usually worth less than 1 USD per share. In other words, the prices are in pennies. They are also considered to be the riskiest stocks you can invest in. They are extremely illiquid and are often listed on exchanges that require less transparency or have low reporting requirements. Many penny stocks multiply in value. But there are also many penny-stock companies that go bankrupt. You’ll lose your investment if this happens.
All bonds are given a credit rating. The lower the rating, the higher the chance of the bond issuer defaulting or failing to pay out. In other words, the lower the rating, the higher the chances of your investment disappearing. Because the credit rating is so low, the bond pays a higher level of interest. Junk bonds have low credit ratings. If they pay out, they pay out very high interest. They are really risky but, on the whole, they have been one of the best performing assets over the last 30 years.
When we looked at the low-risk investments, the bonds were all issued by government agencies or major companies. This is the case with junk bonds too. The problem is that the government or company issuing the bond has a low credit rating. Bonds issued by the Greek government in 2010 were considered to be junk bonds because of the poor financial situation in the country at the time.
Emerging markets securities
There are certain countries where geopolitical turmoil, currency fluctuations and corruption are higher. This means the risk of investing in them is higher. But there is still a very good likelihood of growth. This is why they are known as emerging markets. Bonds or stock from countries in these emerging markets are known as emerging markets securities. Invest at the right time and you’ll see strong returns.
ETFs track indexes to highlight investments. Leveraged ETFs do the same. But they don’t just invest your money. They also borrow extra money to invest it along with yours.
Ratios are used to measure the amount a leveraged ETF borrows in addition to the capital of its investors. It might be a 2:1 ratio or sometimes even a 3:1 ratio. This means you’ll receive double or triple the return rate. If the return goes up by 1% on a specific day of trading, you’ll receive a 2% or 3% return on your investment depending on the ratio. Just note that this is a two-way street. If there are losses? Instead of losing just 1%, you’ll lose 2% or 3%.
An IPO is an initial public offering. This is how it works. A company decides to raise capital by becoming a publicly traded company that appears on the stock market. It’s the first time that the stock of a private company is offered to the public.
The company can also offer investors the opportunity to invest and purchase shares before they are available on the stock market. This is called a pre-IPO. The company is able to set the price of these shares themselves. When you invest, you purchase a certain number of shares at a certain value.
At this point in time, no one really knows what will happen with the shares when they are made available on the stock market. They could increase in value exponentially. Alternatively, they could be met with a complete lack of interest. This might result in the value of the shares plummeting.
Crowdfunding refers to investing in start-ups when they are in their very earliest stages. You usually do this through an equity funding platform. Private individuals are welcome to invest at this same time. The amount you invest determines how many shares you’ll be awarded in the company.
Just be aware that the shares you receive do not usually give you any voting rights and or pre-emptive rights. This means the company might decide to issue further shares. You won’t be able to vote against them doing this. And since you don’t have any pre-emptive rights, you may not be able to purchase new shares ahead of other investors. As a result, your share in the company might be diluted.
Investing in early stage start-ups is usually considered to be very risky. The majority of start-ups fail within five years. But if your start-up succeeds? There’s no saying what the returns might be.
Foreign exchange trading
You’re at a huge disadvantage when it comes to foreign exchange trading. This is because banks, corporate treasuries and fund management companies have instant access to news that could influence the value of a certain currency. Banks are also able to see which currencies large institutional investors are using when they buy and sell. This makes it easy for them to see which currencies will increase or lose value.
But this isn’t all.
Currency is usually traded using a Contract for Difference. How does this work? Let’s say you’re the initial buyer when the currencies are being traded. The initial seller pays you the difference between the currency when you originally purchase the currency and the value of the currency at contract time. Unless the difference is negative. In this case, you pay the initial seller the difference. And if you’re using a Contract for Difference? It’s not uncommon to have the amounts multiplied by 50 to 100. If you win, you’ll win big, but if you lose, you’ll really lose!
Financial spread betting is when you make a prediction on the future price of a certain asset, whether this is a specific share price, a currency pair or an index. You don’t actually own the asset. This means that spread betting is not actually considered to be financial trading. It’s simply betting. And as such, there’s no tax on anything you win.
What has more risk?
Does a municipal bond have more risk than a private debt placement? Is a venture capital placement safer than a derivative? Excellent questions! Although we have quite bluntly split investments up into classes of high and low levels of risk, there are of course different levels of risk within those classes. And indeed, within each of the different assets within those classes. It’s best to gauge the risk of each of these assets on an individual basis. While you can typically be sure that a government bond will have less risk than an IPO, there have been government bonds that have turned sour and there are plenty of IPOs that have paid off.
4.4 Your Ability To Take Risks
The factors involved
There is always a risk when you invest. Because if worse comes to worst, everything you’ve invested and everything you’ve worked so hard for might suddenly disappear. Would this be a minor setback? Would it rob you of the lifestyle you and your family have grown to enjoy? And what effect would it have on your dreams of retirement? It’s time to decide what losing your investment capital would mean to you.
There are quite a few factors you’ll need to examine when determining your ability to take risks:
- Your age
- Your current assets
- Your monthly savings
- Your general annual expenditure
- Your outgoing capital expenditure
- Your rainy-day funds and emergency cash
- Your incoming capital
- Your retirement income
- Fees, costs and taxes associated with your investments
You’ve probably realised that being young has certain advantages over being old. Especially when it comes to your ability to take risks. As you approach retirement, this ability is likely to drop quite a bit. After all, you’ll be far more reliant on an investment after you’ve been sitting on it for forty years. It will (hopefully) have grown larger. And if it disappears? You’ll have nothing to fall back on. But if it disappears while you’re still young? It probably won’t have accumulated as much value. And you’ll still have plenty of time to make the changes needed to overcome the setback and get your nest egg back on track. In other words? While you’re young, you probably have more ability to take risks.
Your current assets
Exactly what are your current assets? It could be the cash you have saved in the bank, the property you’re leasing out, any investments you have to your name and maybe the retirement fund you’ve been slowly adding money to. By knowing exactly what you have, you’re better able to decide how much you can safely and comfortably risk or invest. And how much of an investment you’ll need to make to reach your investment goals.
Your monthly savings
Your monthly savings are part of your current assets. They are also part of your future assets; you’re probably planning on putting a certain amount of money aside every month or year until you retire. The more you put away, the better. Whether you’re putting it into your retirement fund or investing it elsewhere, just make sure you’re sure of what is happening with it. Do what you can to keep your totals adding up.
General annual expenditure
Your general annual spending is based on what you spend on day-to-day costs. This is going to take a little thinking … But how much do you spend every year? Include everything from rent or mortgage payments to the costs of bills, insurances, groceries and holidays. Don’t include things you rarely buy, such as a new car or a Rembrandt painting. By knowing how much you spend on normal costs every year, you’ll be able to work out how much you’ll need to live the same day-to-day lifestyle in the future. Just remember to factor in inflation before you settle on a final figure.
Your outgoing capital expenditure
These are the big costs that you know you have coming up. Are you planning on buying a new home? You’ll need a down payment. Are you about to tie the knot? You’ll probably be spending a bit on the wedding too. Maybe your children are preparing for university, or you know your roof is going to need refurbishing in a few years. And, now that you think about it, you must be due to update your car sometime soon … They aren’t day-to-day costs, but you still want to take them into account when you map out your financial future. And since you know they’re on the horizon, it’s a good time to start saving, so you know you’ll be able to foot the bills when they arrive.
You’ve just lost your job. You’ve discovered a burst water pipe under your home in urgent need of replacement. Maybe you have some costly medical issues that demand immediate attention. Bad news always strikes at the worst possible time. Unlike outgoing capital expenditures, you’re not able to predict problems like these in advance. This means you won’t have time to save up for them. As such, it’s always a good idea to have something set aside for them.
What if your finances are all tied up in your investment portfolio? It might seem like a bad situation, but that isn’t necessarily the case. If you’ve put part of your capital in a low-risk, low-cost investment, you’ll hopefully be able to remove it as needed without too much of a problem. At this point, it’s important to remember that you’ll have to keep something set aside for an emergency. We will look deeper into your rainy-day funds in Chapter 5 about picking your investment objectives.
Your regular income
There are many different types of income to consider. Your wages? Income. The rent you receive from leasing out your investment property? You could certainly consider it to be income too (although the taxman might put it into a different category). You might be receiving dividends on your existing investments as well … Wonderful! All these incoming finances add up. Take a moment to list all the different sources of income you have. Don’t forget to find out how much tax you’ll have to pay on each of them too.
Now, although your income looks fairly secure, it’s best to remember there are potential risks. You might lose your job. The company where you work might close down. Your tenants could move out. And your investments might default. Luckily, you’ve kept something aside for a rainy day and know to take this possibility into account when working out your investment strategy.
Your incoming capital
There might be extra capital that you expect to appear on your bank statements shortly. Is there an inheritance you’ve been informed about? Are you downsizing your home? It’s okay to include this incoming capital in your planning because there’s a level of certainty about it knocking on your door. As for the lotto ticket you have in your hand … Hmmm. It’s probably best not to factor it into your calculations until you’ve actually won.
You’re probably planning on claiming a pension when you retire. How much will it be? You’ll need to know sooner rather than later. It’s (hopefully) going to play a major part in your finances. Because when you tie in your post-tax pension with the return you’re looking for on your investments, you’ll need to make sure you’ll be able to cover all your different living costs. Just remember that your pension itself will attract certain costs and taxes. Include those in your calculations.
Fees, costs and taxes associated with your investments
Okay, prepare yourself … This is the section where things could get ugly. And having warned you, we might as well dive in with everyone’s favourite: taxes. You’ll need to know about taxes because the money you invest in your retirement fund is most likely not taxed when you invest it. Instead, it’s taxed when you withdraw it from your retirement fund. And this is good news: you’re likely to be in a higher tax threshold when you invest this money than when it’s time to withdraw it. This means that you’ll actually pay less tax on it. Make sure you take this into account. Proceeds from other investments may also be taxed. But exactly how this is done depends on which country you’re earning the money in and whether the taxman there perceives it as income, investment dividends or any of a million other complex possibilities.
Depending on what kind of investments you’ve made, and how you’ve made them, you might be looking at quite a lot of fees and costs. What do we mean by ‘quite a lot’? Remember that fees and costs are a big reason many funds aimed at beating the market inevitably turn a loss for investors. They can really add up to huge amounts. Make sure you know about the different fees and costs you’ll be facing before you invest. Find out how much they are and which ones you’ll be paying when you withdraw your investment capital. Factor them in when determining your ability to take risks.
Unfortunately, this isn’t the end of the story. There’s still inflation. Make sure you take it into account. Because the high figure you look forward to having saved might not grant you very high purchasing power by the time you retire. We will look into these aspects in even greater detail at other points throughout this guide.
The good news
Now, after all the taxes and fees, it’s time for some good news. You’re planning in advance. This automatically improves your ability to respond to certain risks. How? You’re preparing for the risks you’re aware of. They won’t surprise you. And you’re making sure you’ll have easily accessible cash to respond to them. It doesn’t necessarily increase the amount of capital you’re investing now, but it does add to your day-to-day enjoyment of life in the meantime.
Bob has just received €100,000 inheritance (after paying all the inheritance taxes). But he doesn’t want to invest it all just yet. Bob is being careful as he works out his ability to take risks. Bob has established the following factors:
- Bob has €100,000 in cash.
- Bob earns €2000/month. He works at a company in a highly competitive industry.
- Mrs Bob earns €2000/month. She works for the government.
- Bob and Mrs Bob save a total of €1000 every month.
- They have a monthly expenditure of €3000.
- The Bob-Mobile is old and will need replacing very soon.
- Mrs Bob is pregnant. When she goes back to work, crèche fees will come to €800 every month for the next three years, until Mini-Bob goes to school.
- Bob would like to start saving for Mini-Bob’s wedding and university fees. At the moment, it will be at least 18 years before he’ll need to pay for these.
- Bob and Mrs Bob will not retire for about 40 years.
- There is no other major incoming capital on the horizon.
Based on this information, how much do you think Bob and Mrs Bob should invest? And when do you think they should invest it? In what kind of investment?
Basically, you need to calculate your ability to take risks based on your existing lifestyle. Whatever your investment goal may be, you should not take on such a great degree of risk that if things do go wrong, you won’t be able to maintain your current lifestyle.
4.5 Your Willingness To Take Risks
Your ability to take risks examines the financial side of risk. Your willingness to take risks looks at the psychological side of it. And both have a major part to play.
Because one of the highlights of investing is relaxing while your money works for you. So, if you’re constantly stressed, unable to enjoy yourself or kept awake at night as worst-case scenarios run through your head? You’ve made a mistake. There’s a good chance you’ve taken on a higher level of risk than you’re willing to endure.
What determines your willingness to take risks?
There are no clear answers here. Sorry. It all depends on your personality; what you feel comfortable with is entirely up to you. However, there are certain factors that may increase your willingness to take risks:
Let’s say you’ve just approached investment for the first time. You’re reading this guide and have quickly noticed that we repeatedly insist that all investments include risk. Okay. Sure. All investments do include risks. However, the level of risk depends on the type of investment. Over time, you might become more comfortable with your role as an investor and with the way everything works. You might be prepared to try some investments that have more risk associated with them. In fact, you might even find yourself looking forward to them.
There’s plenty of information which will urge you to include high-risk investments in your portfolio. But this doesn’t mean that you’re comfortable doing so. Despite the recommendations or advice you keep coming across. And this is fine. If you don’t feel comfortable taking this advice, there’s no reason why you should have to. You’re in charge after all. And at the end of the day? A lot of this information will come from people with no insight into how you feel about investing. They won’t know if you’re awake and worrying at night.
However, as your experience with investment grows, you may become more comfortable relying on the information assembled by other people and the idea of taking potentially greater risks. After all, by then you’ll have more first-hand experience of how risk works. You might also have started to question whether you’ve aimed too low, or wish you had taken on investments with slightly higher risks and higher returns. In other words? While you were not initially willing to take on that little bit of extra risk, you are now.
Of course, this willingness to take risks could also drop over time. While you’re young, you might be prepared to take high-risk options. But as you draw closer to retirement, you could find yourself less and less willing to take on that same level of risk.
Experience and insight are often closely linked. For example: you spend five years watching and analysing the performances of particular types of investments, such as ETFs, and then decide they’re a safe risk. You feel willing to invest in them from your experience and insight. However, this kind of information is usually available from early on. It’s not really the kind of insight we are looking at here.
Instead, in this instance, we are talking about insight into a particular investment. You may have noticed a particular fashion or trend starting to develop. Perhaps you’ve realised a certain factor, whether it’s political, cultural or financial, will increase the value of a specific investment. And this makes you feel more confident and willing to invest in it.
Bob has only ever been willing to put his money into low-risk investments. One day, Bob notices a lot of people have starting drinking gin. He also notices that the new gin drinkers are uber-cool, ultra-fashionable, influential, trend-setting people. And they only really drink one brand of gin: Gin Co.
Bob looks at the share price for Gin Co. It’s quite low. And when he looks up information about Gin Co., he notices that their sales have increased. He then sees they are about to close a supply deal with an international distributor. Bob decides to strike while the iron is hot. Bob moves his capital from low-risk bonds into Gin Co., where there are potentially greater returns. And far more risk. Bob is willing to take the extra risk.
Our different needs have a huge influence on the way we behave. You probably wouldn’t jump off the roof of your building under normal circumstances. You would simply go down the stairs to reach the ground. But if the building was on fire and the staircase had collapsed? You would have a different need. It might even seem like the risk associated with jumping is less than the risk of staying on the top of the burning building. Jumping looks like a fine solution.
But you don’t jump. There’s still a sense of risk you can’t come to terms with.
At least not straight away. Rather than take the risk of jumping, you carefully make your way around to where firefighters have a huge inflatable pillow for you to land on. Only then do you feel willing to jump. Boing!
Now, under normal circumstances, you might not consider making an investment with a certain level of risk attached to it. But what if your current investments are not performing as well as you expected them to? Or you discover you’ll have some pretty large expenses in the next ten years that you hadn’t taken into consideration? You might find yourself willing to tweak your investment plan.
Your needs have now changed. And the extra level of risk? It might not be as scary anymore. And there’s more reason to accept this risk. You’re willing to invest in options that have more risks attached to them. You do your homework, look at what you want to achieve and research the risks involved. You’re still happy to invest. Boing!
4.6 Your Risk Tolerance
Your risk tolerance is made up of your willingness to take risks and your ability to take risks. This is the point where necessity and your feeling of comfort have to find a way to work together to enable you to reach your investment objectives.
Would you bounce back?
For example, you might feel very comfortable investing in very high-risk options. You’re young and if your investment defaults, it won’t matter too much because you’ll still have a few decades in which to bounce back. But this isn’t the only consideration. Although you’re emotionally or psychologically comfortable with the loss of money, you may not be financially capable of accepting the loss. When you’re young and simply don’t have the cash reserves or the high income of someone twenty years older. You still need to be able to access a certain amount of cash in case your car breaks down, your job disappears or unexpected costs appear.
You’ll need to focus on investments that have a low level of risk associated with them to ensure your capital is still there for you. You’ll also need to make investments that offer high liquidity; you’ll be able to retrieve your capital if you need to. In another five or ten years, even though you won’t have as long to bounce back from a failed investment, your risk tolerance could still be much higher than it is today.
Would you feel comfortable?
Alternatively, you might have consulted a financial agent who suggests you invest in high-risk investments. But it’s not worth doing this if you’ll lose sleep worrying about these investments defaulting. Because if you are as stressed as that, you’ve clearly stepped outside your comfort zone. It’s time to dial back the risk to a level where you feel comfortable and sleep properly at night.
This lack of comfort with risk might actually be because of a lack of experience in the investment world. In another five years, with the extra experience behind you, you may decide you feel comfortable making higher-risk investments. Of course, by this time, your age may exclude you from taking the same high levels of risk as you’re theoretically able to take today. This doesn’t mean that you won’t be able to increase the level of risk from what you are happy accepting today.
4.7 Additional Reading
This guide is for educational purposes only, and should not be seen as financial advice.
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