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Understanding Risk

It's wrong to not bring up risk when it comes to talking about investing.


While everybody likes to think about the"sexy" part of investing (the gains), not many are willing to seriously consider the ugly part (the losses).


You can literally dedicate an entire book to the different types of risk involved in investing. This article is meant to provide you with a basic, but effective explanation of what risk is, and how to think about it.


By definition, risk is defined as the probability of losing your principal (original amount(s) invested). Risk can also be looked at as the probability of NOT meeting your financial goals. In either case, risk tends to go hand in hand with uncertainty.


I'm going to sound like a broken record, but one of the main rules of finance is risk versus return. The markets tends to reward risk over time. Without taking risk, you will have a hard time growing your net worth (which is the point of investing in the first place). This is Investing 101.


It's important to note that taking on risk just for the sake of it is not wise. Risk doesn't exactly equal return.


However, it's important to know that generally speaking, someone that takes on more RESPONSIBLE risk over time is likely to see higher returns than someone who is a more conservative investor.


The way you are invested (your asset allocation) is what determines how much risk you're exposed to over time.


Ideally, your investment mix should be in line with your RISK TOLERANCE and FINANCIAL GOALS. That's always important to consider.


Let's talk more about risk-tolerance (your ability to stomach changes in the value of your investments).


It's easy to make the mistake of overestimating your risk-tolerance at first. But, seeing volatility (risk) first-hand is important in order to learn how truly comfortable you are with it.


I had a handful of clients confidently tell me they were "okay with risk" until the markets got choppy, especially in December of 2018. That was my first time really seeing how people tend to overestimate their ability to stomach drops in the market. Lying to yourself about your risk tolerance is never a good idea.


Also know that your risk tolerance can (and will) change with time. That's natural. It's always important to be aware of it, though.


It's also important to understand the risks of the different asset classes. Asset class is another way to say "investment type".


While this can be broken down much more, the three basic types of asset classes are:


-Stocks: Represent ownership in a company

-Bonds: an 'IOU' investment that tends to pay you with interest

-Cash: Meant to hold its value


Generally speaking, stocks tend to be the riskiest, followed by bonds, and lastly, cash.


Said another way, the higher percentage of stocks that you own in your portfolio, the riskier your investment mix. On the other side of the spectrum, the heavier your portfolio is allocated towards cash and (investment grade) bonds, the less risky your allocation is.


The other pieces to the 'risk equation' are your future financial goals and needs


On the topic of goals, it's wise to match the level of risk you take to the amount of risk necessary to meet your goal(s). Your goals are what give you CONTEXT. Context is everything. Day-to-day swings in the market matter much less if you know exactly what you are trying to accomplish, and you know how much time you have to work with.


If your goal is years away and you have some growing to do, it makes sense to take the risk on sooner rather than later. However, if you're close to your goal, it makes sense to be more conservative (assuming you've accumulated enough wealth to meet said goal).


Start taking your financial goals seriously. Even if you don't have them 100% clearly drawn up, if you know what you're trying to accomplish, and you know how much time you have to get there, you're in much better shape than someone who is just throwing darts at a board with their investing.


So how much risk you should take in your investing? It depends. It depends on your risk tolerance, how much time you have to work with, and the amount of growth you need to achieve your goal(s).


Keep educating yourself on risk, and KNOW WHAT YOU OWN. Again, context is everything. If you knew an investment was risky before you bought it, you're less likely to panic when the waters get choppy, as they will.


The people that tend to win in investing are the ones that are patient, understand risk and know exactly what they are trying to accomplish.


I hope this helps give you some perspective on a very important topic.


-Jose











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© 2019 by Jose Hernandez