Understanding Financial Risk: What You Need To Know

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One of the key concepts to grasp when investing is risk.

You may think risk is just limited to how much money you have the potential to lose in the markets. This type of financial risk is called downside risk.

There is another type of risk called opportunity cost or upside risk. This type of risk is related to what an investor might miss out on if the markets have an upswing and the investor is not invested.

In this article we’ll talk about risk in investing and how you can manage it.

Understanding Risk and Your Risk Tolerance

There are risks to all investments.

A general rule of thumb is the higher the financial risk, the higher the possible return.

We can actually refine this rule a bit more. Consider instead that the higher the risk of the investment, the greater the potential for a higher return and the less likely you will achieve that higher return.

In order for you to grasp this relationship entirely, you must know where your comfort level is relative to risk and also be able to correctly gauge the relative risk of a particular stock or other investment against this level.

Balancing the two types – downside and upside – of risks is crucial to successfully investing long-term.

As I stated above, the amount of financial risk deemed appropriate is different for each individual investor. Factors such as age, job stability, health, short-term and long-term goals, play into how much upside and downside risk are acceptable.

While determining appropriate financial risk level is a first step, it is not the end of deciding how to allocate funds.

For instance, investors need to know how they react emotionally to big swings in the markets.  You might for example tend to sell in a panic when stocks enter a bear market. This is emotional investing and I advise against it. I simply stick to my plan regardless of what the market is doing and rebalance once a year. This way I don’t sell low and buy high due to market reactions. If anything in a bear market I may up my investing and tell myself I am buying at a discount.

You might consider a different more conservative approach to compensate for this. This might lead to smart investment decisions and give an overall gain instead of selling before stocks recover.

Common Factors When Considering Risk

There are some general areas to consider when contemplating your relationship and tolerance to risk.

Risk and Losing Money

You should consider if you value safety over growth.

Of course the most common danger is that your will lose money. You can certainly make investments that guarantee you won’t lose money. However this approach removes most of the opportunity to earn a return in exchange for that degree of safety.

Here’s an example of such an investment.

U.S. Treasury bonds and bills carry the full faith and credit of the United States behind them, which makes these issues the safest in the world

However, the price for this safety is a very low return on investment (ROI). If you calculate the effects of inflation and taxes on the earnings, your investment may return very little in real growth

Risk and Financial Goals

Investment goals are achieved through a combination of the following –

  • Amount invested
  • Invested time
  • Return or growth rate
  • Fees, taxes, inflation, etc

As I stated above if you are risk adverse, your return will be lower. You will then need to compensate for a lower anticipated return by increasing the amount invested and the length of time you have it invested.

A modest amount of risk in your portfolio may be acceptable way to increase the potential of reaching your financial goals.

If you diversify your portfolio with investments of various degrees of financial risk you may be able to take advantage of a rising market while insulating yourself from storms in a down market.

Risk Tolerance

As I have said before risk is a personal decision. There is no right or wrong approach.

Younger investors can in general tolerate a higher level of financial risk than older investors because they have more time to recover if things go south.

So, if for instance you are going to retire in five years you most likely won’t be taking extraordinary risks with your retirement funds because you simply don’t have enough time to right things if they go wrong.  I know for me I intend on living well below my means throughout my life and I might do the opposite of this. As my wealth grows I will feel more stable and financially free to take some risks. This is also why I separate my accounts by goals. I sure won’t be going crazy with my retirement money at 65.

On the other hand, being too conservative may well equal a failure to achieve your financial goals.

Understanding Financial Risk Summary

So in this article we discussed what financial risk is and how there is downside risk – loss of money- and upside risk, loss of opportunity.

How much you can tolerate risk is very personal.

Each investor must look at all their goals and personality to determine how best to balance their risk comfort against what they want to achieve long term.

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