Recent news about stocks like Gamestop (GME) and AMC Theaters (AMC) have many investing for the first time. It’s exciting to see people learning about the stock market and thinking about their future. But what is investment risk and why is it important?
Long-term investment strategies are nothing new. But it’s still important to have a conversation about risk.
Investing in the stock market goes both ways. Some days are good, while others are going to feel like your portfolio is falling off a cliff.
Your risk tolerance when you’re investing plays a big role in deciding which stocks to invest in and which ones to pass up.
This concept isn’t just for short term investors either. Long-term investors use risk assessment to build retirement portfolios as well.
So you need to ask yourself, what is your risk tolerance when it comes to investing? And what does that mean for your investment strategy?
What is Risk Tolerance?
Your risk tolerance describes your ability to take a financial loss.
Investing is typically thought of as a well-thought-out financial play. And for long-term investments, that’s largely true. The stock market has generally predictable long-term growth trends. This makes investing for later in life a relatively safe bet for many.
But that doesn’t mean you don’t have to have thick skin when losses or recessions come around.
Risk Tolerance Examples
People who have a high risk tolerance are more likely to make riskier investments. Newer companies and technology stocks have a reputation for being high-risk, high reward.
These companies are considered risky because of their volatility in price. They often lose millions of dollars in startup costs trying to make the next big platform. This could cause the stock’s price to rise and fall quickly over time.
Investing in these types of companies could yield big rewards if the company strikes it big. But if they fail, those investments could become worthless.
Safer investments in a portfolio include things like bonds or treasury notes. These guarantee annual returns, albeit smaller than those possible on the stock market.
As investors get older, they tend to rely more heavily on safer investments. The risk of a recession or a stock market collapse is always there. Having all your funds in risky investments may delay your retirement date as your stocks recover.
Risk Tolerance vs. Risk Capacity
The type of risk you’re willing to take on is subjective. You get to decide how comfortable you are with buying volatile shares.
But something you don’t get much say over is something called risk capacity. Your risk capacity is the amount of risk you’ll need to reach your financial milestones.
Let’s say you are only contributing $200 per month to your retirement account. But based on your current expenses, you need $5 million to retire comfortably!
By putting your investments into low-risk bonds, you’ll never reach your goal. The annual rate of return means you’ll be investing for hundreds of years to grow your portfolio. On average, low-risk investments have a return of about 1 or 2% annually.
On the other hand, if your investments are risky, they come with a much higher rate of return. This could speed up your portfolio growth and get you to your retirement number sooner.
Depending on your risk capacity, you may need to find ways to earn more money. Or you can change your retirement plans so you don’t need as much.
Risk Tolerance Factors
Age: Your age is a big factor in how risky your investments should be. If you’re young, your investments are usually best served to be risky. You’ve got time to recover and a diverse portfolio of risky stocks can still grow aggressively. If you’re older, you may want to think about safer stocks. This is because you’re retiring soon and don’t want your stocks to plummet in value just before you call it quits at work.
Family: Your risk tolerance may also be influenced by your family. A single person in their 20’s can handle a lot more financial risk than a family of four. Talk to your partner or family members about their risk tolerances as well.
Retirement Age: When you plan to retire determines your financial goals. Most Americans aim to retire at 65. Your retirement plan will require knowing how much money you’ll need to live out your days in retirement. Based on when this is will determine how much risk you’ll need to take on.
A good financial advisor can help you balance these tolerance factors to come up with a plan.
Whatever your risk tolerance, know that investment is the most fruitful over the long term. Putting money into your 401k or IRA each month ensures you’re on track for future goals. Your plan may even have an investment advisor who can guide you through an investment strategy.
Risk tolerance and capacity change with time. Don’t feel afraid to reduce or increase your tolerance for certain investments depending on your stage of life.