What Kind of Investment Risk Are You Going to Take?
Posted October 31, 2022
Have you ever heard the phrase “go big or go home”? Or what about the saying, “the biggest risk is not taking any risk”? Have these phrases, or the notion that you should take risks in life, ever impacted your decision-making?
Maybe you’ve always been a risk-taker. You like to push the envelope, dare to do what others won’t, and see how far you’ll go. Or maybe you’ve always played it safer— stayed within the familiar, chosen the path with the least resistance, and dared not to leap when you didn’t see the safety net.
Whether you take risks or play it safe, these tendencies may play a role in your finances, especially regarding investments.
As you build your investment portfolio, you may come to a crossroads where you must determine whether an investment is too great or just the right amount of risk. Then, you will want to understand the risk-reward concept and consider how this investment could play out.
The Risk-Reward Principle
Essentially, the risk-reward principle is knowing that the greater the risk, the greater the potential reward. Understanding this risk-reward tradeoff is essential when managing your investment portfolio. If there is no sizeable potential upside for taking a risk, then there wouldn’t be an incentive to take the risk, and it would be considered careless.
For example, investments like government bonds and savings accounts are much safer than real estate or stocks. But on the other hand, the reward with real estate and stocks is far greater than that with government bonds and savings accounts.
As you’re debating on whether to make a safe investment or accept a higher risk, there are two primary questions you will need to ask yourself.
Question #1: What is my timeline?
Are you investing this money now in hopes that you will have a great return in the next 6-12 months to put a down payment on a new house, go on an extravagant trip, or pay for a child’s tuition? Or, on the other hand, are you investing this money to let it grow over the next 30 years?
If you are planning for a short-term goal, it would be prudent to choose a lower-risk investment. If you make a risky investment with hopes of making a large short-term gain, if the investment doesn’t perform the way you are hoping and it takes a turn for the worse, you won’t have time to recover your losses (and you might be stuck without enough money to cover the goal). However, if you have time to spare, you have more flexibility and can make those riskier choices, and let your investments do the hard work for you.
If you say, “the only way I can afford the short-term goal is by taking an extraordinary risk,” you might be in a situation where you are living outside your means. In this case, you should be looking at reevaluating your goals and creating more realistic short-term goals and develop a plan for achieving them. Hope is not a strategy, and you shouldn’t be relying on it for to achieve financial success.
Question #2: How much am I willing to lose?
No one wants to go into an investment planning to lose money, but no investment in the world is without risk. Risk tolerance is knowing how much volatility and how much you are willing to lose as an investor potentially, and this is key when deciding where to invest. (Source: Investopedia)
Unfortunately, there is no risk-free investment. No matter where you decide to invest your money, you will take on risk. The risk will come in different forms, so it’s essential to understand what you risk you are accepting. Inflation risk affects the conservative investor that invests in cash, CDs, and money markets. With these types of investments, though your account balance might not drop in value, your real-world purchasing power decreases, which is a considerable risk.
If you invest in real estate, you are accepting all kinds of risk like operator risk (you or whoever you higher is bad at operating a real estate business, market risk (RE values drop or vacancies increase due to the economy), location risk (what kind of change is going on in that area), and liquidity risk (it typically takes a long time to sell a house and receive the cash). These are to name a few, but many believe unrealistically believe real estate to be risk-free, which is worrisome. Real estate can be a great investment, but it carries a ton of risk, just like any other asset.
Stocks are no different and have risks associated with them. An upside to owning stocks is that you can easily and cheaply diversify using ETFs and mutual funds and eliminate unsystematic risks. However, you always accept market risk when investing in stocks (this means stocks tend to perform well during a bull market and poorly during a bear market).
Why does this matter?
Our clients must understand the risk-reward concept and allow us to help them make smart financial decisions based on their needs and preferences. Whether our clients are extremely conservative with their investments, aggressive or somewhere in the middle, we are dedicated to working with your best interest in mind 100% of the time.
If you would like to evaluate the risks versus the rewards regarding your portfolio, our team would be glad to meet with you. You can make your appointment with Thayer Financial by visiting our website and scheduling a call today.
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