When you invest money, there is always a risk that you will lose money. At the same time, not investing at all is a risk too, with your savings becoming less and less valuable over time, due to inflation.
The risk associated with investing varies depending on the type of investments that you make. For instance, investing in bonds is a lot less risky than investing in stocks. In the investment world, there is a relationship between risk and reward. The higher the risk that is taken by an investor, the larger the return that they should expect to receive. At the same time, with greater risk comes a greater risk of making a loss.
The safest investments are cash investments, followed by government bonds, corporate bonds, investment funds, stocks, derivatives, collectibles and unregulated investments (i.e. cryptocurrencies).
As you can see, the riskiest investments are the investments that people talk most about these days – stocks and cryptocurrencies. Both of which are not necessarily suitable for most investors, who would perhaps be more suited to less risky options. The investments that you decide to make should suit your tolerance for risk.
Determining what your tolerance for risk is, can often be a difficult task. It depends on what your goals are, how long you intend to invest for and how you feel about losing money. If you are more emotional when it comes to your money, then investing in risky asset classes would probably not be suitable. For example, if the stock market crashed, think about how it would make you feel. How would it make you feel to open your investment account and see positions of -50%? If it is a scenario that makes you feel uncomfortable or anxious, then investing in stocks would probably not be a good idea, as anything can happen in the stock market.
In this scenario, the time that you intend to invest for is really important. If you are intending to invest for your retirement, which is more than 20 years away, then it may be easy for you to just forget about the money and let it ride out economic storms – after all, the stock market usually recovers strongly from a crash within a few years. Likewise, if you really need your investment capital in the short term, then it may not be a good idea to invest in stocks, instead investing in bonds or cash investments.
So, in order to determine your risk tolerance, think about why you are investing, how long you intend to hold positions for and how you think you would deal with the worst case scenario.
When thinking about your risk tolerance, it could be the case that you can clearly identify that you either have low tolerance, medium tolerance or high tolerance. In these circumstances, it would be easy to say that a person with low tolerance should just invest in cash investment and that individuals with a medium or high tolerance for risk should invest in stocks and bonds.
In many cases, however, individuals may not have such a clear cut risk tolerance and may want to invest in a variety of asset classes. An option that such individuals could consider is to build a portfolio that includes a range of different types of investment. If they have some idea of their risk tolerance, they could invest a certain percentage of their capital into each asset class to match their risk tolerance.
For example, a conservative portfolio, that would suit individuals with a low risk tolerance, could include 70% of their money being invested in cash investments, 20% on bonds and 10% on stocks. A moderate portfolio, suitable for individuals with medium risk tolerance, could include 60% of the money being invested on bonds, 20% on stocks and 20% on cash investments. An aggressive portfolio, suitable for individuals with a high risk tolerance, could perhaps include 80% of the money being invested in stocks, 15% in bonds and 5% in cash investments.
It is important to note that these portfolios are purely for demonstration and are not necessarily a recommendation. The main idea is that an investor can create their own portfolio to match their own risk tolerance.
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