- Investment risk comes in many forms including inflation risk, liquidity risk, volatility risk and business risk.
- Risk and return are closely correlated. Conservative, low-risk investments tend to produce lower returns than aggressive, high-risk investments.
- In addition to your risk tolerance, factor in your age, time horizon, anticipated income, cash flow needs and other assets when making investment decisions.
If you had the chance to skydive, would you do it? Often times, your lifestyle’s risk appetite can be a good barometer of your investment risk appetite. In other words, if you would jump at the opportunity to leap out of a plane, you may also be comfortable taking high risks in your investment portfolio. Therefore, it’s important to make an honest assessment of your own risk tolerance. Often times, it’s hard to really know what you’re comfortable with until you’ve experienced losses.
Let’s review the fundamentals of investing risk tolerance. When you understand the various types of risk, you can select investments that are in line with your individual risk preferences.
What is risk?
Every type of investment involves some level of risk, meaning some amount of uncertainty with the possibility of financial loss. Risk tolerance is a way of measuring how much variability in an investment’s returns you are willing to handle. If you take on more risk than you’re comfortable with, you may succumb to emotion-based trading, which can lead to panic selling at lows.
Typically, investors who take higher investment risks are experienced and willing to go for it for the chance to achieve higher returns. We call this “risk-adjusted” returns. Risk and reward are intermingled and can vary significantly by investment product type.
When making investment decisions and gauging risk, it can be helpful to take these important questions into consideration:
- How easily can you get your money out if you need it?
- What are the performance expectations?
- How fast do you anticipate your money will grow?
- Does the investment have a reputable track record?
- Does the investment come with any type of protection?
Risk can come in many forms
In addition, investors should understand that investment products can be exposed to different types of risk. Examples are highlighted below.
- Inflation risk may pose a problem to investors who hold a lot of cash or are exposed to cash equivalents that can lose purchasing power in a rising interest rate environment. The same issue can occur with investments that offer fixed rate of returns that fall behind the rate of inflation.
- Investments that have restricted or thinly traded markets can pose liquidity risk to investors. When investments are illiquid, investors may be unable to buy or sell shares for an extended period of time. Even cash equivalent products like CDs can pose liquidity risk since they often charge penalties for early withdrawals.
- Volatility risk can be more prevalent in some industries and product types such as commodities and equity options. Even if an investment’s fundamentals are fairly sound, political events or market fluctuations can impact its performance.
- Stocks and bonds can pose business risk to investors since their returns are dependent on a company staying in business and remaining profitable. If the company goes into bankruptcy, its assets are liquidated and distributed in a systematic fashion. Bondholders are paid first, followed by preferred stockholders and finally common stockholders. Unfortunately, investors may only get some of their money back or nothing at all when a company is dissolved.
- If you invest in international stocks, there is also currency risk. It is very possible to lose money in a foreign stock if the country’s currency has depreciated more than the appreciation of the stock. Conversely, investors might get a boost if their foreign investment’s currency appreciates during the time of holding.
Balancing risk with reward
Every investor is unique having different needs and goals. As a result, there is no right or wrong amount of risk you should take. The risk tolerance scale in a nutshell ranges from conservative at the low end, moderate in the middle and aggressive at the high end.
Returns tend to increase as investors take on higher risk. Source: Citibank
Options and futures are generally more riskier investments than stocks and government debt. Source: Investopedia
Factor in your age and investment time frame
Your individual risk tolerance level is likely to change as you age and your finances advance. When you’re decades away from retirement and have a long time horizon, you may be more willing to invest in higher risk assets. As your retirement approaches, scaling back to a more conservative portfolio may suit your needs better and help you preserve capital. Learn how you can adjust your portfolio’s asset allocation as you age and keep your financial goals aligned with your changing risk tolerance. Rebalancing and maintaining an allocation inline with your risk preferences can help reduce surprises to your retirement account and help you prepare for the future.
Need some help finding an asset allocation mix that can help you reach your financial goals for retirement? Motif Investing offers customizable horizon asset allocation models, designed to provide an enhanced, low-cost and diversified solution with no monthly fees. Simply open an account, choose a strategic model and select your time horizon. Just a few mouse clicks and you’re on your way.
Other factors to consider when determining your investing risk tolerance include your anticipated income in the years to come, how much money you are comfortable losing if a downturn arises and how well diversified your current assets are.
The more you understand risk and determine your individual risk preferences, the better investment decisions you can make. Expand your knowledge further using our Investing Insights. Ready to get started? Open a Motif Investing account today.
Investing in securities involves risks, you should be aware of prior to making an investment decision, including the possible loss of principal. An investment in individual stocks, or a collection of stocks focused on a particular theme or idea, such as a motif, may be subject to increased risk of price fluctuation over more diversified holdings due to adverse developments which can affect a particular industry or sector. Investments in ETFs can include those with a narrow or targeted investment strategy and can be subject to similar sector risks than more broadly diversified investments. Motif makes no representation regarding the suitability of a particular investment or investment strategy. You are responsible for all investment decisions you make including understanding the risks involved with your investment strategy.
Horizon motifs provide investors with a starting point to consider in allocating assets within their larger portfolio. However, Horizon motifs should not be considered a recommended strategy or comprehensive solution to your overall investing needs. There are many considerations when structuring your portfolio, such as cash needs, family-planning needs, tax and estate planning strategies. Motif does not provide any investment, tax, or legal advice and suggest you contact your own investment, tax, or legal advisor for further information your investment strategy. $0.00 commission for trades (buys, sells, following rebalances) for the benchmark versions of the nine Motif-created Asset Allocation Horizon motifs. Commissions for any Horizon motifs that are customized in any way – adjust weighting, add or remove securities, choose not to following rebalance event, will include a $9.95 total commission per motif transaction or pay $4.95 per stock for individual stock/ETF transactions.
International investments involve additional risks you should be aware of, which include differences in financial accounting standards, currency fluctuations, political instability, foreign taxes and regulations, news that can trigger volatile conditions, and the potential for illiquid markets.
Investments in commodity-related products, such as precious metals, agricultural products, and oil may be subject to greater volatility and liquidity risks than investments in traditional securities. Commodity-related products can be significantly impacted by underlying commodity prices, world events, government regulations, and economic conditions, which can dramatically affect the value of an investment.
 U.S. Securities and Exchange Commission, “What is risk?”, SEC, 2016.