Why is it essential you know your risk tolerance before you invest a single dollar
One subject that comes up a lot in my conversations with friends and family is that of risk. There is a lot of misunderstanding of what risk is, especially in regards to buying stocks.
That’s why I’d like to talk about risk today.
When I use the word risk, I’m talking about the risk of change of price in a portfolio because of volatility. Basically, the more a stock’s price changes, the more volatile (and risky) it is.
When you invest in stocks, you expose yourself to volatility. Higher volatility is usually associated with a higher return. The gist of it is that the more swingy your share’s price is, the more potential returns you can get (Tesla is a popular volatile stock). This is not a fixed rule and there are, of course, exceptions.
Should I be afraid of volatility?
Volatility is a natural characteristic of the stock market. But just because it’s natural, it doesn’t make it easier to handle. Not even one bit.
Seeing their share’s price go down by a lot can be really stressful for some investors. As an example, when I first started investing in the stock market I was fearful of seeing my share’s price go down by even 1%! Now I can handle seeing my shares go down by 30% or more without batting an eye.
However, not everyone is able to handle the stress of seeing their shares go down in value. And so they end up closing them because they fear an even greater loss if they keep them open.
(Now I’m not saying that you should never sell a share in a loss. If your research indicates the company’s prospects are bad, then you certainly should close your trade. But closing it because of negative feelings is something that should be avoided.)
How do I determine my risk appetite?
Each individual investor must be aware of their risk tolerance. Meaning, their ability, and willingness to stomach swings in their portfolio. Your tolerance depends on a few factors. To list a few: your mental fortitude, your investment horizon (how long you are investing for) and your knowledge of the stock market.
Your risk tolerance is one of the factors you need to take into account when you become a long-term investor. Indeed, you will be hard pressed to keep your investments open for a long duration if you see their price drop below your comfort zone.
What if I invest in the whole market rather than on individual stocks?
A useful piece of knowledge to keep in mind is that, as the graph above shows, stock markets have shown to be profitable in the long-term. While short-term volatility is scary and stressful, the economy tends to grow in the long run.
One last thing. Investing involves risk, but so does not investing! Inflation eats away at your purchasing power every year. A better alternative to letting your money gather dust and lose value in a bank account is to invest it, whether you do it on your own or you rely on someone else to do it for you.
The Oracle of FI is a middle-class guy working as a software developer. His goal is to achieve full financial independence by the age of 40.
He started this blog in 2019 in order to share his tips and techniques on investing, saving money and making the most out of life.
He has a cat and lives in France.