Risk and reward are linked. Generally when comparing investment options, the investment which offers the least potential for loss, will also offer the lowest rate of return. On the other side of the coin, the higher the potential return of an investment, the greater the potential for loss. While maximizing your rate of return is important, the first priority is to assess your level of risk tolerance. To help you with this process think about the 3 broad categories that most investors fall into:
Also referred to as “risk averse” this category of investors is willing to tolerate very little if any loss on the money they are investing. The primary focus of the conservative investor is principal protection and, secondary to this, income generation from their investments. The biggest problem with this investment style is finding investments that return enough to beat the rate of inflation.
“Middle of the road”, you are willing to experience some fluctuations in the value of your investments. You are seeking steady growth in the value of your investments, while at the same time avoiding large swings.
Your focus is on growth and you are willing to accept large fluctuations in the value of your investments for the higher potential return that you can get by doing so.
Your financial situation and personal preferences both affect the level of risk you are willing to take, and therefore which of the above categories you fall into. There is generally no right or wrong answer, what’s important is to examine your own situation to see what’s right for you:
As a general rule, the longer the time until you are going to need the money you are investing, the greater the level of risk you can take. This is true for a number of reasons:
If you are planning to use the money you are investing to buy a house in a couple of years, your risk tolerance is probably going to be low. If on the other hand you are saving for your infant’s college fund (where you will need the money in 18 years), your level of risk tolerance is probably going to be high.
The more you depend on the capital you are investing and the income it is generating, the less risk you want to take. A good rule of thumb is that you should never put money at risk that you cannot meet your day to day expenses without.
How would a decrease in the value of your investments affect you psychologically? Some people accept fluctuations as part of the “ups and downs of investing.” For others, it’s important that investments hold their value, even if that means giving up the higher potential return that higher risk investments generally offer.
Using the above information you should be able to decide what is more important to you: generating a high return on your investments or principal protection? The good thing is that you do not have to chose just one. As we will learn in later lessons, through asset allocation, you can create a portfolio which balances your needs for preserving your money with your desires for making good returns.