Your “Risk Level” is how much risk you are willing to accept to get a certain level of reward; riskier stocks are both the ones that can lose the most or gain the most over time.
Understanding the level of risk you need and want is a very important part of selecting a good strategy. For nearly any strategy, whether it is picking stocks or doing asset allocation (picking how much of each type of investment we want) the steps in determining your level of risk are generally very similar. Determining the level of risk and reward needed is a key aspect of determining an investment strategy.
Determining your risk level
- Time horizon: Your time horizon will involve when you expect to use the money you are investing.
For example, a 25 year old who is saving for retirement can go for much riskier investments since if he loses his money in a bear market, he still has a few decades to be able to make his money back. Choosing safe investments for a 25 year old would also not be a good idea since he would be losing out on the opportunity to make a lot more money. On the other hand, someone who is retiring next year will not want to risk losing his or her money if a market collapse occurs right when they retire. They would have no time to recuperate the money and could be in serious trouble, so they will want very low risk investments.
Hence, the longer your time horizon, the higher risk you can afford. The shorter the time horizon the lower risk you should choose.
- liquidity: This aspect is very similar to the time horizon. Essentially someone would not choose an illiquid asset if they had needed the money for that investment in the next month. For example, real estate is considered fairly illiquid as it can take months to years to get a good price on your investment. On the other hand, popular stocks are considered very liquid as they can usually be sold anytime during market hours.
- Investment knowledge: The higher your investment knowledge, the riskier the investments you can take. The reason being that you are more aware of the inherit risks and therefore more likely to make informed decisions. You would not expect someone with no investment knowledge to jump right into currency trading, they would most likely start off with mutual funds or bonds.
For example, a wall street trader will not consider futures to be as risky as someone who has never even traded a stock. The trader will know how to protect himself and have a better idea of the risks involved. It is essentially the old adage “That knowledge is Power” at work, but in this case, Knowledge is Reduced Risk.
- Risk aversion: This is a measure of how comfortable you are with risk. The opposite of risk aversion is risk seeking. The level of risk aversion is usually determined by considering different scenarios and picking the one that one feels most comfortable with.
High risk aversion: You would prefer to invest in a stock that could have gains of 20% but has only lost 5% at most at a time.
Moderate risk aversion: You would prefer to invest in a stock that could have gains of 70% but also loses 20% on a regular basis.
Low risk aversion (risk seeking): You would prefer to invest in a stock that could have gains of 200% but also loses 100% on a regular basis.
- Economic outlook: Unless you are following a very specific contrarian strategy, the worst the economic outlook is, the lower we would want our risk. On the other hand, a great economic outlook would allow us to increase our risk.
- Savings and income: This can have a large bearing on the type of investments you will make. Someone with large amounts of savings but very little income will invest very differently from someone with a lot of income and very little savings. Again, this comes down to your individual goals. In general we would establish with our time horizon whether what our objective is. Whether we are trying to save or have income every year.
- Tax Considerations: Tax considerations are a very complex matter given the large amount of differences in taxes between countries and even within. Tax breaks and savings should not be your main focus at the detriment of picking sound investments. However, it is very important to take advantage of tax breaks whenever possible when investing. Furthermore, there are usually differences between capital gains (for example a growth stock) and dividend gains (dividend stocks) which can make one or the other far more or less attractive than the other. Every location is different so it is important to educate yourself on the taxes associated with each asset.
To summarize, if investor XYZ wanted to know what his level of risk should be for his Investment strategy, he would go through each category and sum up his risk. For example, if XYZ needed his money in ten years, has moderate risk aversion, has very little investment knowledge and there is poor economic outlook. We could say his risk should be somewhere in between low and moderate.
The risk pyramid
Now that you’ve got a better idea of your risk level we can look at the types of investments that are right for that level of risk.
Note: You can mix a high risk asset with a low risk asset to get a similar asset of moderate risk. However, this is not always the case and is often difficult to assess exactly the level of risk, especially for high risk assets. It’s therefore much better to get a moderate risk asset if you want a moderate risk. If you are looking at this in the context of a portfolio you should also look at Asset Allocation.
Creating a Diversified Asset Allocated Portfolio
Here are a few guidelines when trying to create your portfolio:
- Cash: Keep enough cash on hand for daily purchases and small emergencies. It can be wise to keep enough money in your bank account to avoid the fees.
- Gold: Many investors keep a small amount of physical gold and cash on hand. This can be useful in financial crises like the great depression where limits are imposed on the amount of money that can be withdrawn. Gold is also extremely safe and not tied to a countries currency.
- Property: Your house is an investment as it has value and should be considered as such.
- Bonds: They are generally not good investments unless you are trying to protect what you already have. This was not always true however and is dependent on the interest rates.
- Stocks: Diversification of stocks is important and generally the cheapest way to do is with mutual funds or exchange traded funds (ETF). Growth Stocks are generally considered to be riskier than income stocks.
Here are examples of asset classes we might assign to each investor. Note: Asset allocation is not an exact science and can have big differences between one opinion and the next.
Low Risk Portfolio: Retiree with high investment knowledge, very low income and moderate risk aversion.
Moderate Risk Portfolio: Middle aged investor with low income, high investment knowledge and moderate risk aversion with large savings.
High Risk Portfolio: Young investor with good income and high investment knowledge and low risk aversion and high spending with no owned property.