Risk Tolerance
Potential Risks of Investment
When individuals invest their money, they typically have an expectation of how much they will receive in the future. Some may expect to receive more than their initial investment, while others may be content with at least breaking even. These varying attitudes toward investment returns stem from each person’s unique tolerance for risk. It’s important to understand the level of risk you’re comfortable with when making investment decisions.
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Expectations for Investments and Tolerance for Risk
Investing with low or no risk tolerance may seem like a safe choice to ensure the return of the principal investment. However, this choice typically leads to lower returns on the investment. On the other hand, investing with higher risk tolerance may lead to higher returns, but also to a higher possibility of losing money.
Investors need to understand that risk can come in different forms, and the right balance and proper diversification of investments can help mitigate overall risks. By considering these factors, investors can make informed decisions on how to invest their money, taking into account their individual risk tolerance and investment goals.
Types of Risk
Market Risk
Market risk is a key concern for many investors as it encompasses price fluctuations in market-valued investments such as stocks, bonds, real estate, metals, and collectibles. The unpredictability of market risk makes it impossible to forecast price movements, as it is influenced by various factors such as the economy, global events, politics, and investor attitudes.
Inflation Risk
Investors who have a low or zero tolerance for risk face the risk of losing the purchasing power of their saved or invested dollars. Although low-yielding savings options like CDs and money market funds can offer a no-risk solution, their long-term holding may lead to erosion of the saved money’s value due to inflation.
Interest Rate Risk
Investments linked to interest rates, such as corporate and government bonds or any marketable debt instrument, are susceptible to price changes due to the movement of interest rates. The value of these investments tends to move in the opposite direction of interest rates, meaning that if rates rise, the value of the investment will drop, and vice versa.
Taxation Risk
The taxation of investment earnings is regulated by various provisions of the tax code and can be treated differently at different levels of government. However, the tax code is subject to change, which could affect the tax treatment of investment earnings. While tax treatment should not be the primary consideration for selecting an investment, changes in tax treatment could render an investment less appropriate for your circumstances.
Liquidity Risk
Investments that carry market risk can also entail liquidity risk, meaning an investor may be unwilling or unable to sell an investment that has decreased in value. Some investors may feel compelled to hold onto an asset until its value recovers. In certain situations, an asset may not have a readily available market for purchasing it at its fair market value.
Credit Risk
Investors who purchase debt instruments such as bonds or notes from a company undertake the risk that the company may experience financial difficulties and default on the debt.
Controlling or Reducing Risk
Diversify
Investors who invest all of their money in one asset class, such as stocks, real estate, metals, or CDs, expose their money to the highest level of risk associated with that asset class. By diversifying investment dollars across multiple asset classes, the overall risk of the portfolio is reduced because the risk of any single asset is spread out.
Go Long
To mitigate market, interest rate or inflation risks, investments should be regarded as long-term commitments to enable them to withstand the normal economic and market cycles.
Establish a Liquidity Fund
One can manage market downturns by establishing a secure cash fund with adequate funds to meet short-term or emergency requirements.
Quality Investing
Limiting your investment options to financially strong companies can help reduce the risk of default or market loss due to a failed enterprise. Although the stock of quality companies is still vulnerable to market downturns, their likelihood of failing altogether is lower than companies in questionable financial condition.
Investors should always consider the risk that comes with the reward of a return on investment. It’s important to know your risk tolerance level and weigh it against your priorities to determine if you’re able to stay within your comfort zone. If a higher investment return is needed to meet your most important needs, apply risk reduction methods to minimize overall risk.