Your risk tolerance is important to understand when making investments. It should dictate what you invest in.
What constitutes a risky investment? A rental property? Your neighbour wanting you to invest in a multi-level marketing business? Shares and stocks? And why is it that what investment works for other people might seem way out past the shark nets for you?
What is risk tolerance?
Risk tolerance is your ability to manage the potential of losing money on your investment. It’s the willingness to risk some volatility for bigger potential returns. Everyone has a different tolerance for risk, and this changes over your lifetime. Your ability to shoulder the losses amid the gains dictates what type of investments you will be comfortable with.
For example, putting your money in the bank to accrue interest is considered low risk. However, with low risk investments come low returns. If you’re comfortable with higher risk, you stand to potentially make bigger gains.
At the opposite end, a very high risk investment could be something like a newbie company on the stock market. It might suddenly take off and, in a short period of time, you’ve doubled your money. Or the business founder is discovered to be a fraud, the share value plummets, and you’re left with an asset that’s practically worthless.
What affects your tolerance for risk?
Your risk tolerance is influenced by your understanding of financial matters, your age, and most significantly, your personality.
Financial savviness: Knowledge is power and when you know how investment markets work, you’re more likely to make better financial decisions. For example, when the wider economy is depressed, share values fall. People instinctively tighten their belts and are less inclined to spend or invest in businesses that aren’t doing so well. But, short of a catastrophe, good businesses will always pick up. A financially savvy person will recognise that the best time to buy shares in a sound business is when their share prices are low. Buy in gloom – sell in boom. Yet many people who are not so savvy, do exactly the opposite; selling up when values fall and jumping on the buy bandwagon when prices rise.
Age: If you’re close to retirement, your earning potential for the future is very limited. If you experience losses in your investments, you don’t have time to make up for that. As a result, older investors and those close to retirement tend to have a lower tolerance to risk.
Personality: Your tolerance for risk when it comes to financial matters may not reflect your risk tolerance in other areas of your life. Just because you’re an adrenalin junkie who loves to sky dive, bungy jump or race cars, does not mean that you can stomach watching your Kiwisaver account balance fall sharply. It’s important to understand your financial personality too and make financial decisions that make you feel comfortable and that you can live with.
Why does risk tolerance matter?
If the thought of losing money makes you break out into a cold sweat at the mere thought, there are definitely certain types of investment you should avoid. High risk means an increased likelihood of volatility with asset values increasing and falling, sometime quite alarmingly. It’s a bumpy ride and if your preference is for a smooth road, such volatility will seriously challenge your peace of mind. You could well make decisions that are poorly thought out and result in losses. For instance, if the market crashes, a low financial risk person may panic and sell off their portfolio to avoid feeling that panicky feeling you get when you’re convinced it’s all turning to custard; feelings nearly always trump logic. But selling otherwise sound shares when they crash is a very poor strategy as you lock in those losses and have no chance of recovery.
A person with a high financial risk tolerance is less likely to panic. Logically they know the market always recovers, and shares are a long term investment – you ride out the lows in order to get to the highs. And if you’re naturally less inclined to panic, logic has a greater chance of winning out.
When it comes to investing, it’s better to work with your natural inclinations than against them.
What is your tolerance for risk?
Often, it’s really hard to know what you’re truly comfortable with until you have experienced some losses. It is therefore important to be honest with yourself. You might like to think you’ll behave rationally but will you really? A proper assessment of your financial risk tolerance with a financial adviser will help you gain a better understanding of your risk tolerance so you can create a robust financial plan.
Risk profiling helps you choose investment options that meet your investment goals. If you can better predict how you will react to future events, you can simplify the investing process by avoiding altogether the assets and investment types that are not for you.
Why not avoid risk altogether?
In short – you can’t. All investments have risk. Even cash, considered the lowest risk investment available, is affected by inflation. In a very low (or currently next to no) interest rate environment, your earning returns could be so low that you’re actually going backwards. And while bank failures are something we talk about historically, they can and have failed in recent times – Governments might not always come to the rescue with bailouts.
Investment risk changes over time too. For many years in NZ, the most reliable and trusted investment has been property. Our housing market has been buoyant, a seemingly guaranteed risk-free choice for capital gain and rental income. But then COVID struck. The official cash rate dropped and the lending restrictions were eased to encourage spending in a depressed market. But far too much of the available cash found its way into housing causing values to surge (yet again) and investors took advantage. As an investment, housing looked to be a sure bet.
But then unexpected tax changes by the government to curb house prices were announced. Overnight, the ‘sure bet’ Investors could rely on was suddenly a bit less profitable and far riskier.
What’s your investment strategy?
Your financial planner should assess what level of risk you are happy with, and then help you make decisions on asset allocation. They can advise you on a spread of investments, which suit your investor profile.
A planner should also reassess strategies as your wealth grows and your needs change. They understand that timing is important when making decisions. While ideally emotion should be left out of financial decisions, personality does affect choices and the success of the investment. For a better investment strategy, you need to take everything into account.
So, what kind of investments are right for you? Ask Sam Kodi. He can help you make the best decision to suit your personality and financial needs.