Measuring risk – Part 1

What is risk?

In the investment world, risk means uncertainty. It refers to the possibility that you will lose your investment or that an investment will yield less than its anticipated return. Simply stated, risk is the degree of probability that an investment will make or lose money.

When evaluating risk, there are two important elements to understand. The first is the investor’s own ability to tolerate risk, and the second is the risk of the investment itself.

Why is it important (risk vs. return)?

When you make an investment, you plan to make money on that investment, or, more accurately, earn a return. Risk and return are directly related. The higher the risk, the higher the potential return, but also the greater the risk of loss. This fundamental principle is called the risk-return tradeoff.

How does an individual investor evaluate risk?

An investor must consider many factors when evaluating the risk of an investment or an investment portfolio.

Identify financial goals

The first step in evaluating risk is to clearly define your financial goals. For example, if you are young and plan for your investment to provide your retirement, you may be willing to assume more risk in exchange for a higher expected return. However, if you have children who are reaching college age, or you may otherwise need cash within a short time, you may not want to put money into high-risk vehicles. Clarifying the reasons you want to invest can be a key component in determining what level of risk you are comfortable assuming. The following questions may help you to assess your financial goals:

• What do you plan to do with any money earned by the investment?

• How much money will you need?

• When will you need the money?

• Can you afford to forgo the expected return?

• Can you afford to lose the principal?

Understand your risk tolerance

Each investor is able to accept a certain amount of investment risk. This is referred to as the investor’s risk tolerance. The concept of risk tolerance is twofold, referring to both the investor’s desire to assume risk and financial capacity to assume risk. An investor should never assume risk beyond his or her capacity, even if personal desire exceeds that capacity. On the flip side, an investor should not assume risk at full capacity if doing so will make him or her lose sleep at night.

Risk tolerance is highly individual and subjective, depending on a number of factors, including the investor’s age, stage in life, emotional temperament, attitude, and investment experience. Thus, an investor’s risk tolerance is not static, but changes over the course of his or her life.

Because of these changes and because of the emotional component involved, it can be challenging to measure your risk tolerance with a high degree of accuracy. However, there are tests that help estimate an investor’s risk tolerance at a given point in time.

Article courtesy of Forefield.Securities offered through NPB Financial Group, LLC. A Registered Investment Advisor/Broker-Dealer Member FINRA, MSRB, and SIPC