Risk Tolerance – What Every Investor Should Know

play_riskRisk is the chance of losing money due to fluctuations in an in investment’s value.  Usually, risk refers to the short term.  Potential returns are considered in the long-term.  Risk and return potential are fundamentally linked in investing.  Lower risk will have a lower possible return, while higher risk prospects will have a higher potential for return.  Investors often consider the link between risk and return to be a spectrum: on the left side are low risk (and consequently low-return) investments, and on the right side are higher-risk, higher-return investments. The higher the risk of an investment, the higher the potential return from that investment.

The relationship between risk and return is most clearly seen in a longer-term view of an investment.  In the short-term, a high-risk investment very well may underperform a low-risk investment.  In a longer-term view, however, it is much more likely that the high-risk investments will outperform the low-risk investments.  This likelihood increases as the time frame measured is extended—the longer the view, the more likely the higher-risk investments are to see higher returns.

This relationship between risk and return, as well as the relationship between risk, return, and time is one of the most important and fundamental parts of investing.  It allows even the most novice investor to understand what types of investments are and are not ideal for their goals and why.  The most important concept for investors to grasp is that any savings that they cannot afford to lose should not go into higher-risk investments.  Because high-risk investments can pose dramatic gains, they can seem appealing to new investors, but they are also likely to experience significant losses, which would jeopardize the investor’s capitol.  For investors who may need their money within a few years, it is wiser to take a more modest return in exchange for less risk of fluctuation.  However, for investors who have a significant amount of time before they need to access their money, higher-risk investments are often a wiser decision because of the long-term performance expectations of higher-risk investments.

The most important thing an investor can do is to identify his or her goals for which he or she is saving.  These can be long-term goals like saving for retirement, or short-term, such as saving for a vacation, or an emergency fund.  The money allotted to each goal should be invested in the appropriate type of investments.  Someone in her thirties saving for retirement would be best served by riskier investments, because she has time for them to mature.  Someone saving for an emergency fund would want a safer investment to protect their principal and accept more modest returns for lower risk.

Risk tolerance is also an important factor to take into consideration.  Someone who is overwhelmingly concerned about a decline in principal, even if he or she is saving for a goal that would normally demand a long-term, higher risk investment strategy, may be better served by investing in a lower-risk plan in order to maintain peace of mind.

Generally, investors who have a long time frame on their goals, who are able to survive short-term losses, and who have a high enough risk tolerance to withstand a decline in principal are ideal candidates for higher-risk investments which carry a higher potential for returns.  Investors who are saving for a short-term goal, cannot withstand any short-term losses because of their financial situation, or do not have the risk tolerance for short-term losses should invest in investments which, although they carry lower potential returns, are lower-risk.

About Lawrence Meyers

lawrence meyers

Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at [email protected]

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