Looking at investment risk before buying/selling a stock/bond can be compared to a chess player who looks for weaknesses on the board before making a move. A good chess player doesn’t automatically assume that the queen is the strongest piece, or that the pawn is the weakest. Rather, a piece’s value (like an investment’s value) depends on the position of the other pieces around. Based on that information, he evaluates the different risks and decides upon his next move.
Investment strategy is similar. A particular investment’s risk factor depends on outside circumstances.
Why is investment risk so important?
Sometimes an investment can sound so enticing that it can blind you to its inherent risks, especially if it is offering spectacular returns. Though you may make a profit from it, there may be a strong chance of losing money on your investment. Are you able to sustain a real loss? If you don’t ask yourself this simple question before you invest, you could end up suffering a financial disaster.
When considering the risk level of an investment, take these factors into account:
- Your age – if you were to sustain a significant loss, do you have enough time before retirement to recoup what losses? The closer you are to retirement, the less risk you should take.
- What’s going on with the rest of your investment portfolio? Your stock/bond ratio should be analyzed to make sure that your overall exposure to risk isn’t too high or low. The advantages and disadvantages of a particular investment may be offset by the balance of your portfolio.
- What kind of company do you want? If you are looking at investing in a bond, ask yourself if it is backed by the government? Is the stock from an established “blue-chip” company? If the investment is in a solid company that is doing well, the level of risk will be lower than if it is in a new start up, which is more likely to fold.
Sometimes, the risks posed by an investment may not be obvious at all. Do you know what the hidden risks are in stocks? Click here to find out.
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 player, international investment advisor, and Certified Financial Planner (CFP®).