Understanding Investment Risk: 4 Important Things to Know

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Understanding Investment Risk: 4 Important Things to Know

You’ve set aside money for investing after clearing your debts and you’re hoping to embark on the road towards growing your wealth. Before you step on the accelerator and charge forward with your hard earned money, it’s important to first know how much risk you are prepared to take.

In the world of investment, expect some form or degree of financial risks. It’s unavoidable. It could be the risk of losing money or the risk of your money decreasing in value. Basically, if there’s any possibility that the outcome of your investment differs from the expected result, that’s a risk.

Even if you decide to take a ‘safe’ route, the lack of risk comes with a risk too, one whereby you may not meet your financial goals in time. Driving slower might be safer than speeding, but there’s a higher chance that you’ll be late for your important meeting!

Understanding how risk can affect you positively or negatively is essential before setting out to invest. So here are 4 important things to know to help you navigate around investment risk.

1. Identify your risk profile

Understanding Investment Risk: 4 Important Things to Know

So how do you identify the amount of risk you can handle? Certainly not by the cups of nervous sweat accumulated from your palms and forehead when you hear unfavourable news about your investment. There are free questionnaires or calculators easily available online to gauge your tolerance to risk which will conclude by determining your risk profile or investment personality based on your responses to questions.

Generally, investing styles fall into three basic categories: conservative, moderate or aggressive. Your risk profile will then guide the appropriate allocation of your investments. For example, conservative investors would be better suited to invest in fixed deposits to unit trust funds than dabble directly in the stock market.

If you prefer, engage a professional financial planner to help you carry out this risk tolerance process as they need to evaluate your willingness and ability to take risks before planning an investment portfolio that you’ll be comfortable with.

Must read: How Investment-Ready Are You?

2. Understand the difference between ‘appetite’ and ‘tolerance’

Understanding Investment Risk: 4 Important Things to Know

Once your risk profile has been identified, beware of an obstacle — your actual behaviour or decisions could veer off course. There are studies out there that show an investor’s stated belief in risk-taking doesn’t necessarily match their behaviour. For instance, you might believe you are an ‘aggressive’ investor and provide answers during an evaluation according to that belief, but in reality, you might be ‘moderate’.

Your willingness (appetite) and your ability (tolerance) to handle investment risk are not the same. Here’s another way of looking at it. Mr X might have the appetite for a big buffet spread, but he is unable to eat too much owing to a health condition. He could decide to enjoy the buffet anyway but he will be exposed to the risk of getting gout, heartburn or worse. So despite his appetite being high, his tolerance is lower.

In the investment context, say, for example, an investor has indicated that they are comfortable with market fluctuations. However, instead of holding on to long-term shares when the price dips and riding out the volatility, that investor becomes jittery and quickly sells off the shares, making an immediate loss.

Although adjustments can be made to the portfolio, it’s better to stick to a plan than to resort to corrections along the way. The lesson is to be realistic, especially during a risk profile assessment, so that the right investment choices can be made from the start.

Must read: 6 Common Biases That Hurt Your Investment Decisions and How to Overcome Them

3. Know the investment asset classes

Understanding Investment Risk: 4 Important Things to Know

The benefit of knowing your risk profile is that investment decisions can be made to suit your financial and emotional tolerance to risk. Investors with a low level of tolerance are recommended to choose safer, less volatile investments that are less likely to plunge in value. At the opposite end, those with high tolerance would be comfortable making investments where prices can rise and fall dramatically.

Different investment instruments carry varying levels of risk and they are categorized into major groupings comprising similar types of investment. These groupings are known as asset classes with each class carrying a different level of risk and sharing similar characteristics within a class. Here are the main four asset classes:

  • Cash and cash equivalents: This class has the least risk and therefore the lowest returns. Examples include money in your savings account, money market funds, online wallets, cash under your mattress!
  • Equities: This represents ownership in a business. Examples include stocks and mutual funds. It’s the riskiest class due to the volatile nature of the stock markets
  • Fixed income: Lending money to a company or government for interest. Examples include bonds and fixed deposits. They offer better returns than cash but carry more risk
  • Physical assets: Examples include real estate, natural resource commodities and precious metals like gold. Investing in property like an office or apartment can get you good returns via rental income and increased property value, but the entry cost is high.

Knowing these asset classes will help you decide where to park your money, depending on your risk tolerance and growth expectations.

Also read: 10 Important Things Real Estate Newbies Should Be Aware Of

4. Learn to manage risk

Understanding Investment Risk: 4 Important Things to Know

With so many options and variables, it can be confusing to know which financial products to choose from while managing the different risks. Taking the smallest risk could make your financial goals impossible to achieve, but taking too much may lead to major losses.

The solution lies in three strategies: diversification, investing consistently and investing over a long period of time.

For newbie investors, diversification essentially means not putting all your eggs in one basket or not putting all your money into a single asset class. By spreading your money, you spread the risks too. Therefore, aim to maintain a balance of different assets that give you a good mix of safety and higher returns. This way, you won’t lose everything if a high-risk investment sinks, as you would have lower risk assets to keep you afloat.

To guide investors on how to allocate their investments, there is an industry rule of thumb that you might want to practice. It involves subtracting your age from 110 and the number you get is the percentage of your portfolio that should be invested in stocks. So for example, if you are 40, place 70% in stocks (110 minus 40) and perhaps the rest in bonds (30%). To add other assets to your mix, you could reduce your stock allocation to 60%, your bonds to 25% and invest 10% in real estate and 5% in cash.

Ultimately, your investment portfolio should take into consideration factors such as your age, attitude to risk, financial goals and the investment timeline. They are all interconnected. Long-term investors are better positioned to make riskier investments because they can bounce back from any potential losses over time.

This applies especially to younger investors who can afford to take on more risk since time is more on their side. As one gets older one, experts recommend gradually reducing risk.

As such it’s crucial to understand your risk tolerance to ensure you work towards stable investment returns without jeopardising your financial interests.

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