Two reasons why people invest their money are to increase the original sum invested, or to create a source of regular income. Risk is simply the chance that the outcome of your investment will be less than expected. This can include losing some, or all of the initial principal, or not getting the return you had hoped for.
A basic principle in investing is that the more risk you take on, the more return or profit you should expect to earn. It makes sense that you should be compensated for increasing your risk by earning more on your investment.
There is no ‘one-size-fit-all’ rule when it comes to risk and investments. Just like a well-tailored suit, your investment plan must be uniquely designed in order to fit your requirements, your financial goals, and your comfort level, in order to be successful.
When thinking about risk in investment you need to consider the following things:
1. Goals and objectives
What are you trying to achieve by investing your money? Do you want to save towards your retirement at 65, or are you trying to get rich so that you can stop working for money and let your money work for you? Do you want to find the deposit on a little apartment, or do you want to ensure that your children don't have to take out students loans to go to college?
If you know what you want your money to do for you, it will help you to decide if you're willing to sacrifice security for risk, or if preservation of your principal is more important. You have to match your objectives with appropriate investments that will help you to achieve your goals.
2. Time frame
The time in which you hope to achieve your objectives is also important. Generally, when you have longer term goals like retirement or your children's university education, the theory is that you can afford to take on more risks, as you have a longer time frame to recover. The flip side of that rule is that the longer the time frame, the better the magic of compounding can work on a low-risk, low-return savings plan and still help you to achieve your goals.
In fact, people on the verge of retiring with no pension and no investments, will sometimes be more willing to try risky investments in order to play ‘catch-up’. It's best to stay away from riskier investments if you have short term goals to be achieved in three years or less.
3. Liquidity needs
Another key factor to deciding on riskier investments is your need to have your money readily available to you. Liquidity is the ease in which you can get back your cash from an investment without affecting its value. Liquid assets are your savings accounts and most money market investments. Investments that are more illiquid are stocks, bonds and some mutual funds.
If you have a lot of responsibilities that require having cash on hand, you should limit how much money you place in riskier investments. However, if you have your emergency and short term needs fully covered, then you can be more comfortable in trying to gain higher returns on your excess funds.
4. Risk comfort level
Despite the possible benefits of higher returns, sometimes the bottomline is simply: how do you feel about risking your money? I always tell clients if an investment will make you lose sleep at night, it's not worth it. There's a saying in the investment world “Do you want to eat well or sleep well?" Investing in high risk schemes gives you the opportunity to ‘eat’ well, but their risk may prevent you from sleeping well. Similarly, safe-and-secure may make you sleep well, but, you might not end up eating well!
To solve the risk / return dilemma, seek assistance from expert financial advisors who can help you to make the investment choices that are right for you.
© Cherryl Hanson Simpson
Cherryl is a financial columnist, consultant and coach. See more of her work at http://www.financiallyfreenetwork.com and http://www.financiallysmartonline.com