Determine your risk tolerance
How risky do you want your investment portfolio to be? The answer to this question should be determined by various factors, such as your financial situation, your plans and your personal preferences.
Generally speaking, investments that are lowed low-risk by the market will have a low yield. This is why there is a trade off between esteemed risk and esteemed reward. For instance, simply putting your money into a bank account in a stable country is considered low risk, but you will be hard pressed to find any bank willing to pay you more than a meager interest on your money. Investing your money that brand new biotech start up company is considered much more risky, but you do have the chance of a really big reward if the company becomes successful.
Three basic questions
Here are a few basic questions to start out with when you try to determine the best risk-reward balance for your investment portfolio.
- What can you afford to lose?
What would happen if you invested $20,000 in that aforementioned biotech company and lost it all? Would that mean that your entire nest egg for your imminent retirement is gone? Would it mean that you can’t help your kid with college expenses? Or would it not have any huge impact on your everyday life at all? What you can afford to lose is an important guideline when building your investment portfolio.
- What is your time frame for the investment portfolio?
Do you need to build an investment portfolio that starts giving you a return pretty quickly, e.g. investing in real estate and use the rent money for personal expenses? Do you want to spend 5 years saving and investing with the hope of being able to purchase your own house afterwards? Or are you a 35 year old looking to put away money for your retirement?
A common advise is to allow for higher risk when your time frame is long, and lower risk when the time frame is short. If you are saving towards retirement, you can take higher risks when you are 35 years old than when you are 60 years old, because 35 year old you have more time left to rebound from losses and build up the investment portfolio again.
As you can see, it is about time frame rather than age. Do not fall into the trap of thinking that young age = risk risk and old age = low risk. There are definitely situations where a young person should go with low risk investments, while the 65 year old who expects to live for 20+ more years should go with a riskier portfolio.
- How do you feel when you do something that is financially risky?
Some people love taking pretty big financial risks, while others do not cope well with the uncertainty. We are all different, and this should be taken into account when you build your investment portfolio. Also, life events can make us change – you may be more adverse to risk now when you are a parent responsible for two minors, than when you were a single 25 year old with only yourself to worry about.
Your emotional ability to handle risk is important. Your investment portfolio shouldn’t be something that gives you anxiety attacks. If you notice that you are so uncomfortable with the level of risk of your current portfolio that it interferes with your life and well being, change it to better accommodate your personal preferences.
Compensate for risk tolerance
- A daredevil that loves the thrill of taking high risks may need to compensate by actively brining the risk level down for his or her investment portfolio. Otherwise, you might end up taking risks for the sake of taking risks, and not because it is a sound investment choice.
- If your risk tolerance is extremely low, this can also be a problem. Investing always comes with a certain amount of risk, and even keeping your assets hidden away in a safety deposit box isn’t 100% risk free. Being overly risk averse can actually be a risk in itself, if it prevents you from growing your wealth.