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.

Range of Annual Returns on Common Stocks for Varying Time Periods, 1950-2005, from the article "What exactly is risk in the stock market"
Source: http://www.unum.co.za

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.

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4 Responses

  1. Acential says:

    Is the data based on stock indices, or sin­gle stocks?

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