Saving & Investing: Investing and the Risk That Goes Along with It (13th Blog Post)

Unfortunately, risk is a fundamental part of investing and therefore an investment portfolio will contain some level of risk unless it is simply sitting in 100% cash. (And even with cash, which investment experts will often refer to as a “risk-free” asset, there in practice is risk because inflation eats away at the purchasing power of cash. In other words, a dollar today is worth more than a dollar a year from now, two years from now, three years from now, etc.) Investment risk exists on a spectrum, and it is a wide spectrum. Investment returns also exist on a spectrum and, in general, relate to the amount of investment risk one takes. In other words, when it comes to investing, there generally is a trade-off between risk and return. So, when it comes to investing and managing your own personal financial risk that arises from investing, it is critically important to identify your tolerance for risk. Investing is about growing your money, not about gambling. Investing is also a game of probabilities as opposed to certainties. Unfortunately, when it comes to investing, the only certainty is uncertainty.

When one invests, the amount of money that one invests is commonly called investment “principal”. “Risk tolerance” refers to how much of a loss of principal, or how much of a loss in the value of one’s investment portfolio or value of individual investments, one is willing to incur. There are generally 4 factors that tend to determine someone’s level of risk tolerance:

(1) Meaning one’s ability to not become so concerned by the fluctuations in the values of one’s investments that one sells them just because they have fallen in value.

Ultimately, your level of risk tolerance should influence what assets and investment strategies you invest in. Stated differently, the level of risk you’re comfortable with when it comes to your investments should shape what you invest in. Please refer to our 12th blog post (“Saving & Investing: Investing”) for a discussion of the types of financial assets in which people commonly invest.

Different types of assets (e.g., stocks, bonds, cash) have different risk/reward profiles. For example, bonds are typically (although not always) less risky than stocks. And cash is generally less risky than bonds. So in order of typical levels of risk, or “riskiness”:

Given that there generally is a trade-off in investing between risk and return, it should therefore come as no surprise that investment returns over the long-term typically follow the same order:

When you step back and think about the trade-off in investing between risk and return, it makes logical sense. If you are willing to take on more risk, you should expect to be compensated for that higher risk in the form of higher returns.

If, when you become an adult, you are in a position to save and decide that you are interested in taking your savings and investing at least a portion of it, try to classify your risk profile as an investor. Here is one simple framework for doing so:

An investor whose risk profile is described as “Conservative” is an investor who is highly risk averse and therefore wants to take little, if any, risk. Conversely, an investor whose risk profile is described as “Aggressive” is an investor who has a high risk tolerance and is therefore willing to assume substantial risk.

Just as investment risk exists on a spectrum, so do peoples’ appetite for risk. Understanding your own risk appetite is critical. Again, classifying your risk profile as an investor ultimately should affect the risk profile of the assets and investment strategies you invest in. When one invests, it is important to do so in a way that is compatible with one’s risk tolerance so that one can strike the right balance between risk and return. And, realistically, it really is a balancing act.

Investing carries with it risks including the risk of losing money. Investment professionals commonly define investment risk as volatility, meaning the degree to which the values of one’s investments fluctuate (i.e., go up and down). Regardless of what assets you invest your money in (e.g., stocks, bonds, exchange-traded funds, mutual funds), your investment returns will likely vary from period to period – including be negative -- because in practice the values of individual assets fluctuate rather than go straight up. Of course, there is another way in which to define investment risk and that is the risk of a permanent loss of investment principal (as distinguished from a temporary loss).

Investment experts generally agree that investing for the longer-term, rather than for the shorter-term, increases one’s probability of investment success. While there are no guarantees, they point out that the longer one’s money remains invested the greater the probability that one will generate positive returns. Alternatively, when one invests with a shorter-term view, the timing of when exactly one makes such investments becomes a more critical determinant of the success or failure of those investments.

I would love to hear from you. Any ideas, experiences, thoughts, comments and questions….please do share.

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