You might be familiar with the risk-reward concept, which states that the
higher the risk of a particular investment, the higher the possible return.
But, many investors do not understand how to determine the level of risk their
individual portfolios should bear. This article provides a general framework
that any investor can use to assess his or her personal level of risk and how
this level relates to different investments.
Risk-Reward Concept
This is a general concept underlying anything by which a return can be
expected. Anytime you invest money into something there is a risk, whether
large or small, that you might not get your money back. In turn, you expect a
return, which compensates you for bearing this risk. In theory the higher the
risk, the more you should receive for holding the investment, and the lower the
risk, the less you should receive.
For investment securities, we can create a chart with the different types of
securities and their associated risk/reward profile.
Although this chart is by no means scientific, it provides a guideline that
investors can use when picking different investments. Located on the upper
portion of this chart are investments that offer investors a higher potential
for above-average returns, but this potential comes with a higher risk of
below-average returns. On the lower portion are much safer investments, but
these investments have a lower potential for high returns.
Determining Your Risk Preference
With so many different types of investments to choose from, how does an
investor determine how much risk he or she can handle? Every individual is
different, and it's hard to create a steadfast model applicable to everyone,
but here are two important things you should consider when deciding how much
risk to take:
Time Horizon
Before you make any investment, you should always determine the amount of time
you have to keep your money invested. If you have $20,000 to invest today but
need it in one year for a down payment on a new house, investing the money in
higher-risk stocks is not the best strategy. The riskier an investment is, the
greater its volatility or price fluctuations, so if your time horizon is
relatively short, you may be forced to sell your securities at a significant a
loss.
With a longer time horizon, investors have more time to recoup any possible
losses and are therefore theoretically be more tolerant of higher risks. For
example, if that $20,000 is meant for a lakeside cottage that you are planning
to buy in ten years, you can invest the money into higher-risk stocks because
there is be more time available to recover any losses and less likelihood of
being forced to sell out of the position too early.
Bankroll
Determining the amount of money you can stand to lose is another important
factor of figuring out your risk tolerance. This might not be the most
optimistic method of investing; however, it is the most realistic. By investing
only money that you can afford to lose or afford to have tied up for some
period of time, you won't be pressured to sell off any investments because of
panic or liquidity issues.
The more money you have, the more risk you are able to take and vice versa.
Compare, for instance, a person who has a net worth of $50,000 to another
person who has a net worth of $5,000,000. If both invest $25,000 of their net
worth into securities, the person with the lower net worth will be more
affected by a decline than the person with the higher net worth. Furthermore,
if the investors face a liquidity issue and require cash immediately, the first
investor will have to sell off the investment while the second investor can use
his or her other funds.
Investment Risk Pyramid
After deciding on how much risk is acceptable in your portfolio by
acknowledging your time horizon and bankroll, you can use the risk pyramid
approach for balancing your assets.
This pyramid can be thought of as an asset allocation tool that investors can
use to diversify their portfolio investments according to the risk profile of
each security. The pyramid, representing the investor's portfolio, has three
distinct tiers:
Base of the Pyramid The foundation of the pyramid represents the strongest
portion, which supports everything above it. This area should be comprised of
investments that are low in risk and have foreseeable returns. It is the
largest area and composes the bulk of your assets.
Middle Portion This area should be made up of medium-risk investments that
offer a stable return while still allowing for capital appreciation. Although
more risky than the assets creating the base, these investments should still be
relatively safe.
Summit Reserved specifically for high-risk investments, this is the smallest
area of the pyramid (portfolio) and should be made up of money you can lose
without any serious repercussions. Furthermore, money in the summit should be
fairly disposable so that you don't have to sell prematurely in instances where
there are capital losses.
Personalizing the Pyramid
Not all investors are created equally. While others prefer less risk, some
investors prefer even more risk than others who have a larger net worth. This
diversity leads to the beauty of the investment pyramid. Those who want more
risk in their portfolios can increase the size of the summit by decreasing the
other two sections, and those wanting less risk can increase the size of the
base. The pyramid representing your portfolio should be customized to your risk
preference.
It is important for investors to understand the idea of risk and how it applies
to them. Making informed investment decisions entails not only researching
individual securities but also understanding your own finances and risk
profile. To get an estimate of the securities suitable for certain levels of
risk tolerance and to maximize returns, investors should have an idea of how
much time and money they have to invest and the returns they are looking for.