What does it take to be a successful investor? You need a variety of attributes, including patience, discipline and a long-term vision of what you want to achieve. But you also need to understand the role of risk in investing.
When investors think about risk, they typically think of the various risks associated with different types of investments. For example, investments such as stocks carry market risk, which is the risk that you could lose money if you sell shares whose market price has fallen below your purchase price. Other investments – for example, certificates of deposit – offer inflation risk, meaning the fixed return they provide may not keep pace with inflation.
In addition to learning about the risks associated with various investments, it’s also important to understand the following three concepts: risk tolerance, risk capacity and required risk. Let’s consider each of them:
Risk tolerance: It’s useful to know your own risk tolerance. If you are an aggressive investor by nature, you may be willing to take on a higher degree of risk in exchange for potentially higher returns. If you’re a conservative investor, you might lean toward sacrificing higher returns for greater stability of principal. By understanding what level of risk you can comfortably tolerate, you’ll be in a better position to stick with your investment strategy through up and down markets.
Risk capacity: While your risk tolerance defines how comfortable you are with risk, your risk capacity refers to how much risk you can handle based on your financial situation, goals and timeline. When you are young and have many years to invest, you have more time to overcome losses, and so you have a greater ability to handle volatility — a greater risk capacity — than someone who is retired. Also, the more discretionary income you have, the larger your risk capacity, because you won’t be as dependent on your investment portfolio to help provide the income you’ll eventually need for your long-term goals, such as retirement.
Required risk: The higher the return necessary to reach your goals, the more potential risk you’ll need to take on — in other words, the greater your “required risk.” For example, when it comes to retirement, the return you’ll need from your investments depends on several factors: your age, your retirement lifestyle, your available sources of income, your desired legacy and so on. To achieve your goals, you’ll need to find the right balance between the returns you need or anticipate and the amount of risk you are comfortable with.
Ultimately, your challenge will be to balance your risk tolerance, risk capacity and required risk as factors in a comprehensive investment strategy. By creating this strategy and sticking with it over time, you’ll be able to make investment decisions based on your needs and goals rather than emotionally reacting to the constant changes in market conditions.
Over time, of course, your thoughts about risk may evolve to reflect changes in your life and objectives. As this happens, you will want to review your investment mix with your financial advisor, and make whatever changes are required to help you stay on track toward your long-term goals.
