Investing 101: Risk Assessment
Every choice you make in the financial world is a risk. Everything is a balance between risk and reward.
The more risky an investment, the greater the risk that your money might not be coming back to you but along with greater risk, is the opportunity to earn greater investment returns. You have to walk a fine balance between risk and reward.
You cannot completely eliminate risk. If you are too uncomfortable with too much risk and want to minimize it, you would have to go with lower investment returns (which is also a form of risk in itself). Also just a gentle reminder, if you don't take any risk at all, you won't be able to make money through investing.
There are different types of risk and these are some you'd likely take them into consideration when you start to design your portfolio
- Stock-Specific Risk: Any single stock has a specific amount of risk for the investor. If you dabble in only a particular sector of stocks, you can see your investment wiped if fluctuations arise. You can minimize this risk by diversifying your portfolio (buy something other than stocks).
- Risk of Passivity: People who don't trust the financial markets and decide to leave their money in a savings account run the risk of passivity; because they did nothing with their money, they run the risk of losing out on substantial earnings. And since the interest rate of a savings account doesn't keep with up the inflation rate, they end up decreasing their purchasing power over time.
- Market Risk: Every time you invest in the financial market, you run the risk of stock markets declining or crashing and losing your investment. A bigger risk is not subjecting your money to the market risk and not benefiting from the stock market's growth over the years.
- Credit Risk: This is the possibility that a company, agency or municipality might not be able to make interest or principal payments on its notes or bonds. These type of risks are usually associated with bond investments.
- Interest-Rate Risk: For bonds, when interest rate rises, the price of the bond falls (and vice versa). Typically, the longer the maturity of the bond, the larger the impact of interest-rate risk but long-term bonds have higher yields to compensate for the greater risk.
- Economy Risk: Economies have an impact on investments as well. When the economy slows, corporate profits (and therefore stocks) can be hurt.
- Currency Risk: This risk comes about due to currency fluctuations affecting the value of foreign investments or profits. This usually increases in times of geopolitical instability.
What's Your Risk Tolerance?
Your risk level depends on various factors, such as age, financial needs, number of dependents and level of debt. In addition to this, you need to consider your ulcer factor (how losing investments will impact your physical and mental health).
To find out your risk tolerance, let's take a test that was developed by Lincoln Benefit Life. Choose an answer from the choices given and assess your results at the end.
If someone made you an offer to invest 15% of your net worth in a deal she said had an 80% chance of being profitable, you'd say: A. No level of profit would be worth that kind of risk. B. The level of profit would have to be seven times the amount I invested. C. The level of profit would have to be three times the amount I invested. D. The level of profit would have to be at least as much as my original investment.
How comfortable would you be assuming a $10,000 debt in the hope of achieving a $20,000 gain over the next few months? A. Totally uncomfortable. I'd never do it. B. Somewhat uncomfortable. I'd probably never do it. C. Somewhat uncomfortable. But I might do it. D. Very comfortable. I'd definitely do it.
You are holding a lottery ticket that's gotten you to the finals, where you have a 25% change of winning the $100,000 jackpot. You'd be willing to sell your ticket before the drawing, but for nothing less than: A. $15,000 B. $20,000 C. $35,000 D. $60,000
How often do you bet more than $150 on one or more of these activities: professional sports gambling, casino gambling, or lottery tickets? A. Never. B. Only a few times in my life. C. Just in one of these activities in the past year. D. In two or more of these activities in the past year.
If a stock you bought doubled in the year after you bought it, what would you do? A. Sell all my shares. B. Sell half my shares. C. Not sell any shares. D. Buy more shares.
You have a high-yielding certificate of deposit that is about to mature, and interest rates have dropped so much that you feel compelled to investi in something with a higher yield. The most likely place you'd invest the money is: A. U.S savings bonds. B. A short-term-bond fund. C. A long-term bond fund. D. A stock fund.
What do you do when you have to decide where to invest a large amount of money? A. Delay the decision. B. Get someone else, like my broker, to decide for me. C.Share the decision with my advisors. D. Decide on my own.
Which of the following describes how you make your investment decisions? A. Never on my own. B. Sometimes on my own. C. Often on my own. D. Totally on my own.
How is your luck in investing? A. Terrible B. Average C. Better than average. D. Fantastic
Finish the following sentence: My investments are successful mainly because: A. Fate is always on my side. B. I was in the right place at the right time. C. When opportunities arose, I took advantage of them. D. I carefully planned them to work out that way.
After answering each question, give yourself 1 point for each A answer, 2 points for each B answer, 3 points for each C answer, and 4 points for each D answer.
If you scored 19 points or fewer, you're a conservative investor who feels uncomfortable taking risks. If you scored between 20 and 29 points, you're a moderate investor who feels comfortable taking reasonable risks without a great deal of discomfort. If you scored 30 points or more, you are an aggressive investor who is willing to take high risks in search of high returns. You are not greatly stressed by taking significant risks.
For most investors, the two most effective ways to manage risk are to limit your aggressive exposure to a small part of the whole portfolio and to stick with your program once you have embarked on it.