When considering investment options, the primary focus for most investors is return or how much they will make from their investment. Too often, risk is ignored or if acknowledged, with little more than an attitude of 'hoping for the best.' Yet, without risk, there is no return even with stock of high performing 'blue chip' companies. Below are frequently asked investment risk questions and answers as well as how to determine your personal risk tolerance:
Q. What is investment risk?
A. It's simply, the possibility of loss and in terms of investments, that loss may be incurred either as lower than expected returns on an investment or total loss of what was invested.
Q. Is there a way to completely avoid risk?
A. If there is no risk, there is no return. However, you can minimize risk. The biggest risk is not to risk at all. That guarantees no returns, which means no finacial development that would lead to financial security or freedom.
Q. What is a high risk investment and what is a low risk one?
A. Generally speaking, high risk ventures give high yields and within a shorter amount of time, whilw low risk investments have less returns over a longer period of time. This is refered to as risk-return trade off.
A simple illustration would be speeding to get somewhere. Speeding presents a higher risk of getting an accident but if that doesn't happen, the speeding driver gets there faster. The driver who takes his time will spend more time getting there but the risk of getting into an accident is lower.
Q. How can one in terms of investments arrive at a higher yield while minimizing their risk or chance of 'accidents' in form of losses.
A. Still with the speeding driver, he may decide to speed because he has taken precautions like driving on routes whose curves and bends he is familiar with and slow down on rough or risky spots.
So it should be with investments; you should choose areas where you can 'drive fast' or trake more risk and where you should 'go slow' or take less chances. an investor who does that has a balanced portfolio.
Q. Precisely how does one determine which investment routes are the best for them to successfully arrive at the high yields terminal?
A. Every person's ability to take a hit or risk tolerance is different. Your age, which would imply that one has been investing over time and has done enough to acquire basic assets like a home and a car is a factor.
If you have been a prudent investor over time, you can afford to take more risks that aperson who has just joined the workforce and is laying their finacial foundation. They should therefore, not go for high-risk investment options, as a big loss as this would push him significantly in the early stages of their financial life when thay are supposed to accumulating wealth. You should monitor the stages and signs of your finacial planning to know how big to risk in your investments.
Q. Are there specific types of investment risk?
A. There are various types of them but the three main ones that most directly affect yields or returns are inflation risk, market riak and management risk.
Q. How do they affect returns and how can they be minimized?
A. Market risks are dependent on the particular market one invests in, be it stocks, bonds, the money market and other options. Market risk rises and falls in response to the overall economic climate of an area at a particular time. It affects factors that determine the performance of a company, so that it can or cannot offer good returns like high dividends or high share prices.
Q.Minimizing market risk
A. Spreading the risk between various types of investments such as sctocks and the money market is one way of minimizing market risk. You may also choose to invest in foreign markets like offshore investments and take advantage of exchange rates that work in their favor.
When one area fails to yield good or expected returns, the other investment would yield at least well enough so that one does not suffer.
Q. Inflation risk
A. This is the risk encountered by not making any investment at all. Inflation which is loss of the purchasing power of a currency, is guaranteed even in the best performing economies globally. Simply put, what $ 100 could buy one year ago, is less than what it can buy at present.
Q. Management risk
A. This risk refers to the possibility that stocks, mutual bonds or other forms of investment you have bought into or the broker buying on your behalf may not yield good returns as a result of poor management that may cause the value of the investment to fall.
The natural reaction people have to a company they learn is not doing well is to get rid of the stocks at the current price, which is ideally higher than the price they bought it at before everyone else rushes to get rid of it at a lower price as demand for it falls.
Q. Minimizing management risk
A. This is a difficult risk to minimize because you may only learn of the bad performance of a company when it has already gone down or it is about to.
One way to do so is to rely on a credible financial advisor or stock broker frim that is likely to have inside information on the performance of a company and to stay informed, being keen on reading and listening to business news through the various media.
Q. Are there other risks, hidden sort of?
A. There are others, like political risks which comes about when plitical instability affects the performance of companies negatively, heightening the risk of low returns. There is also liquidity risk, which occurs when there is lack of demand for investments you may want to sell such as stocks, whose share prices could be falling and everyone trying to sell off to minimize on losses.
The first three, however, are the most likely to be a factor all the time compared to pilitical risk; they are the ones you have control or choices over.
Q. What are the most common investing mistakes people make?
A. Investing for quick or short-term returns such as pyramid schemes , or buying stocka with the aim of selling them soon after at a profit. Those are very short-sighted and high-risk options, such as the pyramid scheme saga where people collectively lost billions. People only saw very quick, high returns and didn't bother to investigate the legitimacy or sustainability of these schemes.
Following the crowd and buying stocks of a certain company because everyone else is doing so is also ill-advised. those who bought shares, even of the best performing companies, sure that the share price would rise and they would make a tidy profit learnt the hard way, that there is no such thing as a risk-free investment. Those who bought with the long-term return outlook are not as rattled by falling share prices and that is the right approach.
Panic buying and selling of stoxks at the slightest drop in stock prices is another common mistake and this is mostly done by those who buy with the hope of very short-term gains.
These are the people who are also likely to be investing monay they don't have, such as borrowed money, which they need to refund, perhaps at an interest or money meant for other uses in the future that they are confident they will have made. The golden rule is to invest only what you can afford to lose.
Q. How does one determine personal risk tolerance?
A. Investments that don't give you sleepless nights or anxiety as you wait the outcome of a good or bad return is the risk you can tolerate. The way to go is to balance your option, which spreads the risk rather than stick with one option, say of stocks, which is what most people do.
Q. Balancing your portfolio
A. The ideal mix of invesment options is that which reduces risk in high-yield options while maintaining a base of low-risk options.
Low risk: Treasury bonds, long-term bonds and the money market are some low risk investment options that should form the bulk of your investment portfolio.
Mid level: In the middle are options like real estate options, mutual funds and high income bonds which are quite stable and offer good yield probability. These should be worth less than the low risk options.
High risk: These include stocks of companies that are doing well and you may be willing to buy and take a long-term approach on. These should form the smallest percentage of your portfolio and should only be worth as much money as you can lose without causing a serious dent on your overall finacial standing.
Remember, the biggest risk, is not to risk at all and the best risk is a calculated one. With understanding it is possible to stay in step, keep the balance and arrive at the terminal of high returns.