By Ken Little
Risk is a part of investing in stocks. You can’t avoid the risk, but you can decide how much you are willing to take.
Not all stock investments are equal when it comes to risk. Smaller and newer companies are a greater risk than larger, more established companies are.
Of course, in a severe down market, it may feel like every stock is in a free fall.
The question is how much risk are you willing to take?
In general, the higher the risk, the larger the potential reward should be.
You should expect more conservative investments to produce lower returns.
The task for investors is to match their tolerance for risk with investments that will meet their financial goals.
But, how do you know how much risk you can tolerate?
A variety of “tests” on the Internet purport to measure risk tolerance.
I don’t put much value in these tests. Here’s why: When nothing is at stake, people tend to over-estimate their tolerance for risk.
A good analogy is playing poker for chips that you get for free contrasted with playing poker for real money.
There is a significant difference in the way you play the game. When nothing is at risk, you may make wild bets and outrageous bluffs. However, when your actual money is on the table, most people will play much a much more conservative game.
Another way to think about risk is to consider this scenario:
If I offered you an investment and said, “there is an 80 percent chance this investment will be profitable,” many people would say that’s a reasonable expectation.
However, if I said, “there is a 20 percent chance this investment will lose money,” many people would say that is too much risk.
Yet, it is exactly the same investment. The point is how you view your money and risk determines your risk tolerance.
Most people know instinctively that some risks are too high, but not every investment presents an obvious risk you can gauge.
For most investors, finding their risk tolerance is a matter of experience.
It is important that you avoid letting friends or your broker talk you into an investment that keeps you up at night.
You may need to adjust your financial goals to reflect a lower tolerance for risk, but keeping your risk at a comfortable will help keep you on track with an investment plan.
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