We all have an innate understanding of risk, whether we’re crossing a busy street, working on a construction site, or placing a wager on a horse.
Some people are also more eager to accept it than others. For instance, whereas some individuals won’t even get on an aircraft, others will gladly leap out of one (although with a parachute).
But when it comes to investing, the danger is more a question of explanation and possibly some reassurance than it is a matter of common sense and instinct. This article’s goal is to help you manage investment risk so that you may increase your chances of achieving your objectives and becoming a successful investor.
The best way to approach investment risk
The risk I’m referring to is, in its most basic form, the possibility of experiencing financial loss. However, this type of risk is not exclusive to investment. It still remains if you aren’t aiming to increase your financial position. Keep cash hidden away, for instance, and inflation will reduce its purchase value. Furthermore, it could be taken. Again, if money is left in a bank account earning a pathetic rate of interest, inflation will reduce the value of the money.
what time frame?
The second thing to think about is the fact that investment risk is a continuous phenomenon. After all, you could keep the investment for a long time. Even if your investments lose money one year, they could gain money the following year. Only if you really incur a loss by cashing out on your investment do you do so. Up to that point, it is a paper loss. Perhaps painful to look at, but still a loss on paper.
As a result, the longer you anticipate investing (due to how distant your objective is), the bigger the investment risk you may be willing to accept, and vice versa.
As a result, it is reasonable to conclude that if you are in your 30s and saving for retirement, you have more leeway to possibly take greater risks with that money than if you are saving for a shorter-term objective, like a home deposit or wedding. This is due to the fact that you should have more time to weather any changes in the value of your investments.
Risk measurement and management
How can you invest in a way that best represents your risk preferences now that we’ve spoken about investment risk and how it affects you?
Let’s start by thinking about why some investment kinds are perceived as being riskier than others in order to provide a solution. This is mostly due to how they have performed in the past, specifically how widely their returns have fluctuated over several years. Their perception of danger increases with the size of the spread. Also the opposite. Although past performance cannot predict future performance, it can act as a guide.
Investment-grade bonds, a category of loan to governments and corporations that can be purchased or sold on markets and typically pay interest, have typically proven to be less erratic than shares. Investment risk and the concept of investment return are closely related since, on average, they have had more moderate losses and profits than shares.
So, in principle, you should be able to control the level of risk in your portfolio by adjusting the ratio of bonds to shares you possess. The risk increases with the number of shares you own whereas it decreases with the number of bonds you own.
Remember to diversify.
Academic research supports the idea that choosing the appropriate mix of stocks and bonds to invest in might have a greater influence on your results than anything else you do. Finding the balance between risk and profit that works for you is key.
One more word of caution: everything said above is predicated on the idea that your assets are diversified, meaning that they are dispersed throughout a variety of shares, bonds, and markets.
This is crucial because additional kinds of risk may surface when you examine certain bonds and shares in more detail. Will this business issue a profit warning or will its expansion outperform forecasts? Will increasing oil prices assist this firm or have a negative impact? And so on.