Understanding Risk

When you choose to invest, you are putting your money into an investment vehicle that has the potential to turn your initial deposit into a larger payout later on. However, the market will fluctuate both up and down. Even if you lose money in a short time period, future market increases will likely account for temporary setbacks. Investing is all about how willing you are to withstand the volatility of the market. The greater risk you take, the greater earnings you have the potential to receive over time.

Before you start, consider your:

  • Financial goals: are you buying a big-ticket item in the near future? Or saving for retirement or a future major purchase?
  • Time horizon: when do you want to spend the money?
  • Risk tolerance: how much money could you stand to lose?

Each of these factors will determine how much risk is appropriate for your investing strategy. If you’ll need the payout soon, consider a short-term investment with low risk. If you’re saving for retirement and you’re in your 20s, you could probably stand to risk quite a bit in the present in hopes for a greater payout in the future. Identify your investing strategy and then implement it!

Identify Your Risk Tolerance

If you’re still not sure, consider taking this quiz to identify your risk tolerance. 

Risk In Practice

Now that you generally understand risk, you're probably wondering what that looks like in practice.

The assets we’ve talked about so far—stocks and bonds—are quite different in their risk. Bonds are often referred to as fixed income because you are almost always guaranteed the payout you expect. It’s possible that the borrower may default and fail to pay you back, but that is unlikely with reputable bond issuers (like the federal government). There are other risks associated with bonds, but generally, purchasing a bond will return what you expect.

Stocks are much more variable (or volatile) because they depend on the performance of the company. Thus, they are much riskier than bonds. When you buy a stock, it is hard to estimate what return you will receive over time (if any). Nonetheless, the greater the risk, the greater the return.

Diversification

Risk can be reduced by diversifying your portfolio. Diversification is the act of purchasing different types of assets, some riskier than others. This means that even when one aspect of your portfolio is performing poorly, the rest of it could be performing well, resulting in a net gain. Mutual funds and ETFs are based on the idea of diversification. Basically, don’t put all your eggs in one basket and you will probably be okay.

Learn more about investing risks at Investopedia.