Understanding your risk level is one of the most important parts of financial planning. Here’s why:
Imagine you’re playing chess and you’re about to move your queen to a particular square. Making this specific move may put pressure on your opponent’s king, but when you look at the entire board (the big picture view), you see that you might also lose your queen in the process. Is your possible gain worth the risk of losing your most important piece? You need to evaluate the risk-reward ratio of your move… both in chess and in investing.
Risk of loss vs. possible gain
Generally in the finance world, the riskier the product, the greater its potential for gain – and loss. Every investor needs to balance the odds of losing money against the possibility of a profitable outcome.
Ask yourself: What would I do if one of my investments dropped 20% in value? Would I be able to continue meeting my financial goals? Would I sell and lock in the losses or do I have the time before I actually need to use the money, such as when I retire, to hold the position (or another) and try to recoup the losses?
It helps to avoid euphemisms.
“Risk” is simply a more acceptable way of saying, “you might lose money.” Among financial analysts, common synonyms for the word “lose money” are “market correction” or “adjustment.” These expressions can make losing money sound more palatable. However, when you want to understand your own risk level, don’t ask yourself if you could survive a 20% drop in your account. Try using more specific figures: “How would I react if my portfolio dropped $30,000?”
That’s what risk really feels like.
What are the risks you should avoid?
Apart from examining your own personal risk level, look at the possible risks involved in the investment itself. Here, risk doesn’t just mean a fall in the stock’s price. There are other considerations, such as a rise in the price of commodities (such as gas or oil). Even if the investment you are looking at isn’t a commodity, it may still be affected as a result. This is because commodities are used as raw material in production or for transportation. If production prices in other industries rise as a result of increases in manufacturing costs, this can also affect the profitability of the companies you own, and in turn, their stock prices.
What other risks are there in investing? Click here to find four other hidden risks when you invest.
Douglas Goldstein, co-author of Rich As A King: How the Wisdom of Chess Can Make You a Grandmaster of Investing, is an avid chess fan, international investment advisor and Certified Financial Planner (CFP®).
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