When it comes to building your wealth, it’s all but impossible to do so without assuming some type of risk. Some of the most effective means of creating wealth — investing in the stock market, starting a business, etc. — come with a significant level of risk. Even if you make educated, thought-out decisions, there are always factors that could limit your level of success or even cause losses.
However, the possibility of loss should not hold you back from making the moves that will increase your bottom line.
Understanding Risks and Rewards
In the financial world, risks are directly related to rewards. In other words, the higher the risk, the higher the reward when things go as planned and the greater the loss if things go awry. The lower the risk, the lower the reward — but the potential losses are also lower.
To manage risk, many investors turn to the risk pyramid. At the bottom of the pyramid, you’ll find those investments considered “safe” and have a reasonable likelihood of some type of return. In the middle are slightly riskier investments, such as real estate, stocks and equity funds. These investments generally have some rate of return, but you could also experience loss here. At the top of the pyramid, you’ll find the riskiest investments, such as futures and options, which present a high likelihood of loss, but also a chance of significant rewards.
The makeup of your pyramid depends on your risk tolerance. More conservative investors may have most of their money in the lower portion of the pyramid, while more aggressive investors have larger summits with only a small portion of their funds in the base of the pyramid. The key is determining your tolerance for risk and placing your money accordingly.
What Is Your Tolerance for Risk?
Every person has his or her tolerance for risk. Before making any investment decision,you must determine your risk tolerance.
Ask yourself these questions:
When will I need the money that this investment earns? In general, the sooner you will need the money, the less risky your investments should be. Because stock market fluctuations happen quickly, you need to wait out downturns and sell when the price is higher.
In retirement planning, younger people are generally advised to put their money in riskier, long-term investments, with the idea being that, over time, the fluctuations in their portfolio’s value will even out. People who are closer to retirement are usually advised to put the bulk of their money into “safer” investments that will provide more steady growth. The rate of return may be lower than that of a more aggressive investment, but there is less risk that you will lose the principal.
What is my goal? Your tolerance for risk is also determined by your goal. If you simply want to build a strong financial portfolio over time and have money to spend, you may be more tolerant of risk. For example, if you are putting your money away in savings, you will build your wealth more quickly if you choose to place it in slightly riskier investments rather than a simple savings account with a low interest rate. While putting a large amount of money in an investment with a lower rate of return for a long time will earn some money, inflation and changes in the tax rates will reduce your overall earnings. But if you are saving for a short-term goal, such as purchasing a home, you are better off choosing lower risk options to avoid losing your principal.