What is your risk level?
Your ‘risk level’ is how much risk you are willing to accept to get a certain level of reward; riskier stocks are both those that can lose the most or gain the most over time.
Risk
Understanding what level of risk you need and want is a very important part of choosing a good strategy. For almost any strategy, whether it’s picking stocks or doing asset allocation (choosing how much of each type of investment we want), the steps to determine your level of risk are generally very similar. Determining the level of risk and return needed is a key aspect of setting an investment strategy.
Determine your risk level
– Time horizon: Your time horizon will mean when you expect to use the money you invest. For example, a 25-year-old saving for retirement might go for much riskier investments because if he loses his money in a bear market, he still has a few decades to be able to earn his money back. Opting for safe investments for a 25-year-old would not be a good idea either because he would miss out on the opportunity to earn much more money. On the other hand, anyone retiring next year will not want to risk losing their money if a market collapse occurs just as they retire. They would not have time to recover the money and could be in serious trouble, so they will want very low risk investments. Therefore, the longer your time horizon, the higher the risk you can afford. The shorter the time horizon, the lower the risk you should choose. – Liquidity: This aspect is very similar to the time horizon. Someone would basically not choose an illiquid asset if they had needed the money for that investment in the next month. For example, real estate is considered quite illiquid as it can take months to years to get a good price for your investment. On the other hand, popular stocks are considered highly liquid as they can usually be sold at any time during market trading hours. – Investment knowledge: The higher the investment knowledge you have, the riskier the investments you can take. The reason is that you are more aware of the succession risks and therefore more likely to make informed decisions. You wouldn’t expect someone with no investment knowledge to jump straight into forex trading, they would most likely start with funds or bonds. For example, a Wall Street trader will not consider futures as risky as someone who has never even traded a stock. The trader will know how to protect himself and have a better idea of the risks. It’s essentially the old adage “that knowledge is power” at work, but in this case, knowledge is reduced risk. – Risk aversion: This is a measure of how comfortable you are with risk. The opposite of risk aversion is risk seeking. The level of risk aversion is usually determined by considering different scenarios and choosing the one you feel most comfortable with. High risk aversion: You would prefer to invest in a stock that may have a 20% gain but has only lost a maximum of 5% at a time. Moderate risk aversion: You would prefer to invest in a stock that may have gains of 70% but also loses 20% regularly. Low risk aversion (risk seeking): You would prefer to invest in a stock that may have gains of 200% but also loses 100% regularly. – Economic outlook: Unless you are following a very specific contrarian strategy, the worse the economic outlook is, the lower we would like our risk to be. On the other hand, a good economic outlook would allow us to increase our risk. – Savings and income: This can have a big impact on the type of investments you will make.
Someone with large amounts of savings but very little income will invest very differently from someone with a lot of income and very little savings. Again, this depends on your individual goals. In general, we would establish with our time horizon as to what our goal is. Whether we are trying to save or have income every year – Tax considerations: Tax considerations are a very complex issue given the large amount of differences in taxes between countries and even within. Tax deductions and savings should not be your main focus at the expense of choosing sound investments. However, it is very important to take advantage of tax breaks whenever possible when investing. Furthermore, there are usually differences between capital gains (for example, a growth stock) and dividend gains (dividend stocks) that can make one or the other much more or less attractive than the other. Every location is different so it is important to educate yourself about the taxes associated with each asset. To summarize, if investor XYZ wanted to know what his level of risk should be for his investment strategy, he would go through each category and sum up his risk. For example, if XYZ needed his money in 10 years, has moderate risk aversion, has very little investment knowledge and there is a poor economic outlook. We could say that his risk should be somewhere between low and moderate.
The risk pyramid
Now that you have a better idea of your risk level, we can look at what types of investments are right for that risk level. Note: You can mix a high-risk asset with a low-risk asset to get a similar moderate-risk asset. However, this is not always the case and is often difficult to assess accurately the level of risk, especially for high-risk assets. It is therefore much better to get a moderate risk asset if you want a moderate risk. If you are looking at this in the context of a portfolio, you should also look at Asset Allocation.
Create a diversified asset allocation portfolio
Here are some guidelines when trying to create your portfolio: – Cash: Have enough cash on hand for daily purchases and small emergencies. It may be wise to have enough money in your bank account to avoid fees. – Gold: Many investors keep a small amount of physical gold and cash on hand. This can be useful in financial crises such as the Great Depression where limits are placed on how much money can be withdrawn. Gold is also extremely safe and not tied to a country’s currency. – Real estate: Your house is an investment because it has value and should be considered as such. – Bonds: They are generally not good investments unless you try to protect what you already have. However, this was not always true and is dependent on interest rates. – Stocks: Diversification of stocks is important and generally the cheapest way to do is with mutual funds or exchange-traded funds (ETFs). Growth stocks are generally considered riskier than income stocks.
Example
Here are examples of asset classes that we can assign to each investor. Note: Asset allocation is not an exact science and can have large differences between one opinion and the next. Low Risk Portfolio: Retiree with high investment knowledge, very low income and moderate risk aversion. Moderate Risk Portfolio: Middle-aged investor with low income, high investment knowledge and moderate risk aversion with high savings. High Risk Portfolio: Young investor with good income and high investment knowledge and low risk aversion and high spending without own property.
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