5 Smart Investing Principles – Know Your Risk Profile
In our last post we went over the first of five “Smart Investing Principles,” Estimating Your Time Horizon. Today we are going to take a look at the second one, Know Your Risk Profile.
How much tolerance do you have for risk?
It’s easy to say, “I can handle a high level of risk,” but that may or may not be the case. It’s a good idea to ask yourself some pointed questions and be honest with the answers.
What happens to my outlook if the value of my investment drops?
How much could I lose and stay in the market?
It’s also helpful to ask yourself, “How would I describe my investment knowledge?” There are some television programs that help people understand investments and how markets work. But if most of your investment knowledge has come from television personalities, you may want to consider getting a second opinion on your approach.
Here’s another helpful series of questions to ask yourself.
What would you rather have, $500 right now or a 50% chance at $2,000? Many people go for the $2,000, and rightfully so. Since you have a 50/50 chance, a decision tree shows the $2,000 answer carries a potential value of $1,000.
But let’s add a few zeros and see if that changes your perspective. What would you rather have, $50,000 right now or a 50% chance at $200,000? The decision tree says the opportunity to win $200,000 has the highest potential value. But in reality, many people second-guess that decision because $50,000 is a lot of money.
Remember, there is no correct answer to the questions. They simply help you better understand the concept of risk.
Risk can come from different sources.
For example, there are external risks that may influence the price of a stock. That is, sources of risk that are outside a company’s influence. These may include economic risk, market risk, interest-rate risk, political risk, and tax risk.
Let’s take a closer look at one of those risks: market risk. If the overall stock market trends lower, many stock prices would be expected to trend lower as well. Conversely, if the market trends higher, many stock prices may move higher.
It’s like the old expression, “A rising tide lifts all boats.”
On the other side of the scale are company-specific risks. These are risks that are unique to the company, such as a delayed product launch, unexpected expenses, supplier problems, and a management shakeup. By buying stock in an individual company, you are agreeing to accept a certain amount of company specific risk.
Principle 3: Diversification
About Amit: I am a first generation American, the son of a working-class Indian family, and I lived through my parents’ struggle to find their place in this country, to put down roots that would sustain them as well as their children in a new land. As they encouraged me to excel in school and fostered my hobbies and interests, I was keenly aware of the dynamic between them. I understood that there was a difference between where they came from individually and where we were now. They worked hard in their individual capacities, but they weren’t always on the same page about financial issues – and that can make or break a family’s future. I didn’t know it at the time, but this laid the groundwork for my passion towards financial services and helping families succeed.