Everyone lives with risk everyday so why, asks a reader recently, “is risk so confusing when it comes to investing my money?” The answer lies in how most investors interpret the meaning of risk in financial markets.
A simple definition of risk is the probability that an outcome will be different from what you expected. Most commuters bear a risk. We drive to work and expect to arrive on time. Do it enough and we’re able to predict our arrival time within a minute or two. If we drive faster, we arrive sooner but our risk of not getting there at all increases. If it snows, a different kind of risk presents itself and maybe we drive a bit slower. The point is that we become familiar and comfortable with these elements of risk because we have learned gradually over a lifetime of commuting to cope with them.
We’ve also learned to make money at our jobs despite the risks. It normally requires time, effort, experience and maybe sweat or sacrifice. The risks are worth the rewards. With that earned money we buy a house, put the kids in school, save for retirement or pay medical bills.
On the other hand, we’ve been told that investing in stocks, bonds or any other investment vehicle is a lot riskier than we think. Worse, most of us lack experience in financial markets. Take my mother, (who is not wealthy); for her, the markets are a big black hole where investing becomes an all or nothing, win or lose proposition. It’s a crapshoot: she can’t afford to lose, so she won’t play. Year after year she chooses to shop for a better CD rate although she knows intellectually that she could get a better return in stocks or bonds. She is not alone. Most of us view the markets in the same way. Fear and greed, we all want the returns but don’t want the risk associated with it. No wonder we’re confused. The trick is to identify at what price (return) you are willing to take on more risk without giving yourself an ulcer.
On a personal basis, there are two kinds of risks we need to recognize in investing–financial and emotional– and your emotional make-up plays a very big role in how and in what you invest. For example, a multi-millionaire could lose $50,000 in the markets with little financial impact but emotionally the loss might give her ulcers. Someone else with much less money might bet the farm and be able to sleep soundly all night. Your risk tolerance is a very personal issue. Unfortunately most brokers, investment advisers and business writers do not recognize how subjective it truly is. My advice is to listen to that inner voice. .
The global stock markets over the last few weeks have been on a roller coaster with both bonds and stocks gyrating up and down on a daily basis. If these kinds of market fluctuations keep you up at night or make your stomach churn, than you are most likely investing too aggressively. As a rule of thumb, if you have little experience in investing, consider yourself a saver more than an investor and would immediately sell out your investments if the markets dropped 15%, than you should count yourself a conservative investor.
On the other hand, if you have a long-term view, can take the market’s ups and downs in stride with only a bit of discomfort while withstanding short-term losses, and are fairly knowledgeable about securities investing, then you are most likely an aggressive investor, those who fall somewhere in between would be considered moderate investors.
Remember, these are just simple guidelines. They do not account for other elements that make up your risk tolerance like investing experience, age, life circumstances, net worth, and actual investment vehicles you may be contemplating. The key to obtaining your optimal risk versus reward balance is a gradual investment approach.
My advice is to try a progressive investing strategy. Begin by putting only one third of your money into a conservative portfolio. See if it fits your risk profile. Get used to the idea. Notice how the investment returns stack up against money market or CD rates. Take the investing process at your own pace. Add another third of your investment when you are ready. Gather experience before moving on to riskier investments. Step out of your comfort zone one toe at a time and only occasionally at first.
Once you have a bit more experience you can consider your time horizon. Will you need this money in the next few years? If so keep it safe (U.S. Government Treasury bonds for example). However, if it is retirement money and you have a decade or more before you need to touch it, then you might want to explore a more aggressive stock fund or two but the point is do it gradually. In an earlier column, I stressed diversification and mutual fund investing as a way of reducing everyone’s risk without sacrificing long-term returns. Funds are less risky than stocks and a portfolio of bonds; cash and stock funds are less risky than investing in a single asset class. The point is that money should not become a burden. If it is keeping you up at night then your investment approach needs to be overhauled.