Not all investors are created equally when it comes to risk
August 18, 2016
Investment risk is a large part of investing. Assessing your risk tolerance requires you to look at your willingness to accept investment risk, and your financial ability to assume it.
Government of Canada bonds are low risk and considered one of the safest forms of investment. You lend the government money and they pay you interest every year until the bond matures, and then they return your capital.
Alternatively, you could buy an individual stock in a new and growing industry that has a chance of paying huge returns, but the risk is very high. You might lose all your money.
Somewhere in between these two examples is likely the type of investment portfolio you would consider. Some conservative bonds augmented by a strong selection of different and conservative stocks.
Over the long-term, stocks will most likely provide a much better return. Particularly now during our extremely low interest rate environment.
If your intent is to avoid risk you could hold more bonds than stocks. But is that a good strategy?
That would reduce your investment risk but it could potentially increase the risk of failing to meet your long-term objectives. If you are planning for retirement many years away it is unlikely your earning power is high enough to allow you to save adequately for retirement when only receiving low returning bond interest.
Your willingness to take on risk includes the risk of not achieving your goals.
Now let’s look at your ability to assume investment risk.
If you received a hot tip on a good investment that was speculative, the first thing to consider is if you have the ability to assume additional risk. That depends on your financial situation.
If you have extra money you can afford to lose without repercussions to your lifestyle, then you have the option of considering a risky investment. This does not mean you would purchase the investment, just that you have the ability to accept that level of risk.
If you are like most people without huge amounts of extra money to spare, then you are not likely to have the ability to deviate from your sound, long-term, financial plan to incorporate riskier investments in your portfolio.
Deciding on your willingness and ability to accept risk is an important part of building your investment strategy. There are many other considerations including your personality and your aversion to accepting risk.
Understanding the amount of uncertainty you can handle from an emotional perspective, combined with an understanding of the short-term risks that should be taken to achieve your long-term objectives, is an important part of the process.
Investing involves risk. Understanding your willingness to accept investment risk, as well as your financial ability to assume it, are important considerations when it comes to investment decisions.
Fortunately, you have a fair degree of control over the amount of risk you accept.
My recommendation is to make a list of all the risks you face and then set your priorities to determine what the appropriate course of action is for your situation.