The word risk features prominently in financial discussions and literature. Some people have mental associations that cause a negative reaction to the term, but within the financial industry risk is not undesirable.
Risk is the chance to lose part or all of an investment in exchange for the chance to earn gains. Generally, a greater risk of financial loss means a greater chance for a higher financial gain.
Volatility is a large part of the measure of risk, and some financial experts actually define risk by saying that it is the amount of volatility an investment is expected to have. For long-term investors, like retirement investors, volatility is the primary measure of risk.
Every single investment involves risk, and investment advisers help individual investors to measure how much risk is acceptable.
A risk assessment is a test – an in-depth analysis, investigation and evaluation – of how risky a particular investment is. In assessing risk, financial analysts study all aspects of an investment, including volatility, predictability, historical losses and gains, investment history, investment management, investment research team, the amount of money held in the investment and many other factors. A good risk assessment considers both known and unknown quantities. An example of an unknown quantity: how will this investment actually perform during a market downturn? An example of a known quantity: how long has this investment option been in existence?
The outcome of a risk assessment reveals whether an investment is more conservative or more aggressive. It also could reveal whether an investment is simply bad. For example, an investment that is very risky, but has consistently delivered low returns could be considered a bad investment. Investors should only take on more risk if there is the chance to receive a larger return.
Some people are more comfortable with risk than other people. Personalities are different, and there is nothing fundamentally better about being a risk-taker or a risk-avoider. Risk tolerance is a financial industry measure. It refers to an investor’s willingness to take risks and ability to stomach losses.
- A high risk tolerance means an investor is aggressive and will find satisfaction in taking higher levels of risk in exchange for the possibility of higher rewards. It also means the investor can tolerate larger losses, knowing that there might be larger gains later.
- A low risk tolerance means an investor is conservative and will take comfort in preserving principal, knowing that lower-risk investments will mean lower returns.
Personal Situation and Risk
In addition to risk tolerance, there are other personal considerations that affect the amount of risk an investor should take.
- Time horizon: How much time do you have until you will need to access your investment? This factor measures the likelihood that you will have time to recover from a decline in value before you need to sell a portion of the investment to meet a need. A short time horizon is generally associated with a conservative investment portfolio while longer time horizons allow investors to be more aggressive.
- Investment preferences: Do you have any personal preferences, biases or hang-ups that cause you to want to seek or avoid a certain investment type?
- Personal situation: Are you ahead or behind in saving for your investment goals? What things in your life might make it easier or harder to save and invest enough to reach your goals? How might your income or goals change in the future?