Just like everything else in life, many financial endeavors entail some level of risk.
11 min read
These statements are intended to provide general information and do not constitute investment advice or any other advice on financial services and financial instruments such as stocks and ETFs. These statements also do not constitute an offer to conclude a contract for the purchase or sale of stocks and ETFs. Stocks and ETFs can be subject to high fluctuations in value. A decline in value or a complete loss of the money invested are possible at any time. The values depicted are fictional and for illustrative purposes.Taking risks is an important part of life. From riding in cars to climbing a step ladder, we make hundreds of choices each day without thinking much about the risk involved. When you take a risk, you recognize that an action you’re taking might lead to a negative outcome. And yet, often our greatest successes — a promotion, a fulfilling relationship, a stunning view after scaling a cliff — are the result of taking calculated risks. Just like everything else in life, most financial endeavors entail some level of risk. In this article, we look specifically at the risks involved in investing, and how to think about them when setting up your own portfolio.
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In the world of investing, risk is defined as taking an action that could result in you losing some or all of your principal balance. For example, when you invest your money in a stock or ETF, you take the risk that the company will fold or the stock market will crash. However, some risks are worth taking when you look at the possible returns you might see. Let’s look at an example. Say you invest €1,000 in the stock market, with a plan to trade or sell off your assets in a year’s time. With a little luck, the stock price goes up at the end of the investment term to €1,150, and you’ve earned €150 on your investment. The risk of investing your money for a short time period paid off. However, if the stock price goes down to €900, this means you’ve lost €100 at the time you need to sell. In this case, you’ll have to decide whether you’re better off keeping your money invested to see if the market swings up again, or cutting your losses and selling your shares right away.Understanding the different types of risks that different investments can incur and acting with this knowledge in mind, as well as having realistic expectations, are some of the best ways to mitigate them. It’s also the best way to get the most out of your investment over the long term. But there are so many factors that impact the risks we take and how we measure them. Let’s take a look.
Risk tolerance vs. risk capacity
When it comes to investing, there are two key ways of thinking about the risks you can afford to take: risk tolerance and risk capacity. Risk tolerance is the level of psychological comfort you have with financial risk, while risk capacity is the level of risk you can reasonably take on given your practical conditions. Risk tolerance has a lot to do with your disposition. Some people are simply wired to stomach risk better than others. They may make bold choices in life and in finance in the hopes of meaningful returns. Others have a low risk tolerance, and find the idea of playing fast and loose with their hard-earned cash untenable. And though your level of risk tolerance is highly linked to your personality, it may change over time based on your age, economic status, and other life events. Risk capacity, on the other hand, is tied directly to objective factors and obligations that may wax and wane throughout your life — including your age, family status or dependents, income, debt level, the job or financial market, and more. It’s not tied up with how willing you are to take financial risks, but whether it would be prudent to do so. Let’s say you’d like to invest 50% of your income in stocks. Now, you may believe intrinsically that this is a great idea, and that you can more than tolerate the risk. However, if you’ve got a mortgage, a less-than-stable job, and a baby on the way, your risk capacity will likely be lower, making it unwise to invest this much of your income. Achieving a good balance between your risk tolerance and risk capacity is an important part of cultivating a solid investment strategy. They also make up something called your “risk profile.” The more you understand your intuitive approach to risks as well as your ability to take them, the better off you’ll be.
Weighing risk vs. reward
For investors, understanding the relationship between the risks they take and the rewards they hope to gain is paramount. This calculation, known as the “risk-return tradeoff” is the balance between an investor’s hope for the lowest possible risk and the highest possible returns. Basically, you’re assessing what you’re willing to put on the line or risk losing to get a great outcome.Let’s say a family member asks you for a loan. You may not be willing to do it for free, but what if they offer to pay you back with an interest rate of 1%? The lure of the reward for taking the risk might outweigh its potential negative impact. The same goes for investing. In many cases, the more you put on the line, the more you stand to gain — or lose. Buying shares of a single up-and-coming company is a daring move, financially speaking. Companies, after all, can go bankrupt, suffer from market crashes, or be impacted by new laws or regulations. However, when a company does well, their shareholders may reap the benefits. Conversely, if you invest your money in government bonds, you’ll have much more security on your investment. You also won’t earn exceptionally high returns. Simply put, the bigger the risk, the higher the possible return. And, the bigger the risk, the higher the possible loss. Of course, there are sophisticated mathematical formulas that seasoned investors and brokers use to calculate the ratio of risk vs. reward. If you’re interested in diving in deep, start out with the risk-reward calculation — a formula where you divide your net profit by your maximum risk. Learn more about it here.
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There are plenty of risks to think about when investing your money. Unstable markets, political regulations or sanctions, currency devaluation, inflation, and high interest rates are just a few factors that impact your portfolio’s success. Financial experts think about these as belonging to two categories: systematic and unsystematic risk. Let’s take a closer look.
Systematic risk
Also known as market risks, systematic risks are types of risks that can affect the entire financial market or a whole market segment. Economic factors, political or regulatory changes, health crises, and climate disasters are all examples of systematic risks that impact the overall performance of the market. Subcategories of these are interest-rate risk, inflation risk, and currency risk.
Unsystematic risk
Non-systematic risk is much more concentrated, affecting a company or industry rather than the entire market. When you make an investment in a company, the non-systematic risk of that investment may be that the company goes under or that the market segment goes through challenges or a regulatory change.
Other types of investment risks
But risk profiles in investing get much more granular than systematic and non-systematic. Here are a few of the other types of risks that investors may bear in mind:
Business risk: This is the ability of a company to generate sales and make a profit. Some factors that impact business risk are the company’s expenses, profit margins, and the level of demand.
Liquidity risk: Liquidity risk is how able you are to sell your investment for a profit at a given time.
Credit risk: Credit risk represents the possibility that the borrower will be unable to pay back their loan or interest as planned. It’s especially important for bond holders, particularly if the bond is from a private company (corporate bond) rather than a government.
Interest rate risk: Here, the risk is that your investment will lose value because of a change in national interest rates. For example, when interest rates go up, some types of investments (like bonds) decrease in market value.
Inflation risk: Inflation risk refers to the potential loss when your investments don’t keep up with inflation, decreasing your purchasing power.
Political risk: Political risk is the potential negative impact of political changes or instability on an investment. This may be a change in leadership, a foreign policy change, or other geopolitical factors.
Portfolio allocations based on risk
Once you’ve understood your individual risk profile and the various risks involved in investing, you can select your investments based on the level of risk you’re willing to take on. In general, this means allocating the percentage of capital you have in stocks (most risky), bonds (less risky), and cash (pretty safe) at predetermined percentages to either invite or minimize risk/returns. Investing portfolios are as individual as the people they belong to, and there’s no one way to set one up. However, financial advisors often divide investing allocations into three general categories: conservative, moderate, and aggressive.
Conservative
Moderate
Agressive
30% stocks
60% stocks
90% stocks
40% bonds
30% bonds
5% bonds
30% cash
10% cash
5% cash
In a conservative portfolio, the investor would minimize risk by keeping stock allocations relatively low at 30% or less. They may hold 40% or less of bonds and keep a significant amount of cash on hand. A portfolio with a moderate risk allocation may invest just over half of their capital in stocks. The other 40–50% would be invested across bonds and cash.The aggressive portfolio is the one taking on the most risk. With up to 90% stocks and a very low percentage of cash and bonds, the investor is putting up significant funds in the hopes of earning high returns. A portfolio allocation like this is most sensible when an investor is young and has a longer time horizon to ride out market volatility.
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While there’s no way to completely eliminate risk when investing, there are things you can do to mitigate risk and keep your investments as stable as possible.
Understand your risk profile. The better you know yourself, including your capacity and tolerance for risk, the easier it will be for you to select investments and allocations that feel right for you.
Do your research. Knowledge is power! The more aware you are of investing basics, micro- and macroeconomic trends, and general personal finance, the more competent your decisions will be.
Diversify your portfolio. Variety is the spice of life — and of investing. Diversifying your assets (through ETFs, for example) gives you exposure to plenty of different industries, companies, and government bonds, so that you’re not putting all your eggs in one basket.
Rebalance periodically. When you’re invested in different assets over the long-term, some of your allocations may get off balance. Check your portfolio regularly to make sure you’ve got the percentages that you’re aiming for.
Have realistic goals and expectations. Although many of us can speculate on what the market will look like in the future, no one really knows. So, as you’re making your investment plan, it’s a good idea to keep your options open and be ready to pivot if things don’t go as you planned. There’s a reason for the old advice about not counting your chickens before they hatch!
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FAQ
People typically benefit from the highest risk tolerance when they’re young and just starting out in their careers. At this point, their risk capacity — the life conditions that allow for investing — is also high, as they likely won’t have other financial burdens like a mortgage or children.
Many find that their tolerance for risks decreases as they age and take on more financial responsibilities. Many financial advisors also urge their clients to decrease the amount of risk in their portfolios as they near retirement, so that any potential market crash won’t wipe out their hard-earned savings.
High-risk investments are investments where the chance is high that you could lose some or all of your principal balance — that is, the money that you initially invested. Types of investments that come with higher levels of risk include stocks and cryptocurrency, but extend to other even more risky forms, such as options trading.
In general, the more volatile an asset is, the greater the potential returns and losses. This means that high-volatility investments (like options or cryptocurrency) are linked to greater risk in investing, while low-volatility investments like bonds or savings products are less risky.
People with a high risk tolerance may be drawn to investing in assets that have historically been more volatile, such as cryptocurrency or stocks. Alternatively, they may opt for a more aggressive allocation of assets in their portfolios, with most or all of their money invested in stocks or ETFs rather than bonds or cash.
When you’re deciding what to invest in, it’s important to think about what level of risk you’re comfortable with, and how much risk you can realistically afford to take. Just like any other risk in life, investing your money can lead to massive gains — or massive losses. You’ll also need to think about how soon you might need the money you’re investing, and whether you have time to ride out a possible market dip.
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