Whenever you invest your money you incur some level of risk-whether large or small—you take the risk of losing all of your investment. When investors are evaluating whether a certain risk will offer an acceptable investment return, they first need to understand the process for determining the level of risk for individual investments and their total portfolio in relationship to your tolerance for risk.
The thinking goes that the more risk you’re willing to take on, the more return you should receive for taking the higher risk. The lower the risk you take, the lower the return you should receive.
The following scale classifies risk from highest to lowest:
- Very aggressive
- Moderately aggressive
- Moderately conservative
Investors can use the scale as a guideline for choosing investments and allocating their portfolio. Investments that fall in the top categories offers above-average returns. They also have a higher potential for risk of below average returns. Conversely, investments that fall into the low risk categories are safer. As a trade-off, they have a better propensity for a higher investment return.
Riskier investments have higher volatility and price changes.
Investments in the “very aggressive” grouping would include commodities, options and collectibles—only invest what you can afford to lose. Investments in the middle grouping encompass real estate, mutual funds, exchanged-traded funds, large-cap and mid-cap stocks, and high-income bonds. Treasuries, money markets, bank accounts, certificates of deposit, notes, bills, bankers acceptance and other cash equivalents make up the low-risk category for risk.
Determining your risk preference
There are a broad range of investments, stocks, bonds, mutual funds, exchange-trade funds, commodities are just a few of the categories. There is no set model for how much risk a person should take on because the needs and preference s vary and people are different.
Here are two factors to consider when deciding on the level of risk you will accept for an acceptable investment return:
Time horizon – Consider the amount of time you have to keep your capital invested. For example, if you need $25,000 as a down payment for your new home next year, you probably should not invest the money in an aggressive investment like high-risk stocks.
In this case, the investor should consider conservative, low-risk investments at the lower end of the above scale. A person who has a ten-year time horizon before purchasing a home could take on a higher risk for an acceptable investment return. If the market turns down, the person still has time to recover the money and avoid selling out to early and taking a loss.
Investment capital – You should approach your investment by only investing money you can afford to tie up for a significant period of time and what you can afford to lose This approach will prevent you from selling off investments to help out in liquidity difficulties or as a result of a panic because of a market down turn.
The more investment capital, the higher the risk you can take. If you have a $100,000 net worth and invest $20,000 in a particular stock and another person who has a net worth of $1 million and buys $20,000 of the same stock, you will experience a greater affect your portfolio investment return and net worth if share price declines.