Anyone who's ever played poker knows that different players have different takes on risk. There are those who step out on the thin branches every chance they get, betting big and relying far too heavily on the bluff. Meanwhile, others take a conservative approach to the game and are apt to fold early rather than risk any loss.
When it comes to investing, it's the same. Each of us carries around attitudes about risk that determine the decisions we make. In poker, you stand to lose the money you brought with you that night. But in investing, you stand to lose a whole lot more if you don't understand the basics of risk.
Risk is one of the most misunderstood areas of finance so let's take a moment to review what all investors should know.
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Know What Your Risk Tolerance Is
Risk tolerance is the degree to which you can withstand varying swings within your investments.
If you are risk-averse, you may be the type of person that keeps all your money in a savings account. This conservative money move can only yield conservative returns – typically less than 1% interest with today’s rates. This low tolerance for risk can wind up hurting you, because inflation will slowly chip away at your savings and you may not be able to build up enough money to sustain yourself in your retirement years.
And if you are a riskier investor, you may take on too much risk by investing aggressively in stocks or other types of investments that have the potential for large returns … and substantial losses. The danger with riskier investments too close to retirement is that you could compromise your financial stability by not having enough time to recoup your losses.
There is a balance between taking on enough — but not too much — risk, based on where you stand today and what you want your money to help you accomplish in your lifetime.
Know What Your Risk Capacity Is
Your risk capacity is a measure of how much of a loss you can handle without severely jeopardizing your financial goals and well-being.
Your age and how many years you are from retirement are critical factors in determining your risk capacity. When you are in your 20s, your risk capacity should be higher than when you are in your 50s for the simple reason that you have at least 30 years until retirement and can more safely ride market volatility.
A good rule of thumb is that the more time your money has to work on your behalf, the higher your capacity for risk.
Know How to Judge Risk
Appropriately judging financial risk requires objectivity and discipline. We all know what it looks like when people make emotional investing decisions. They could be on the hunt for the next big opportunity, like a Google or Amazon. They reactively act to hearing a stock tip from a media figurehead or a friend. They are fearful when everyone else is fearful and make money decisions based on their emotions rather than sound reason.
The truth is, risk is always present when it comes to your finances; there is no such thing as a risk-free investment. In fact, some risk must be present in order to receive a return, but you want to take smart, calculated risks that make the most sense in your situation.
Know What to Do with Risk
Being fully aware of your financial needs and goals and your personal capacity for risk will help you make informed decisions about your finances along the way. Financial growth happens when you take calculated risks with your money. You have to be willing to let your money go to work for you, but it’s imperative that you invest properly according to your risk tolerance and follow a disciplined investment strategy that protects you from reactive or impulsive actions when it comes to your money.
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