Your Investment Risk Tolerance
How much risk can you handle? Let’s look at our illustration again. When most people look at this illustration, they immediately gravitate to the 8% to 10% high risk section. So far, those rates of return look the best. However, when it is pointed out that a return of 8% to 10% is accompanied by the risk of loosing 30% of your investment any given year, many people recoil at that thought and move to something a little less risky.
If you chose to go for a medium risk investment, you are looking at the possibility of losing 15% of your investment on any given year. If that is still too much risk for you, you can opt for a low risk investment. With high quality low risk investments, you can potentially lose 5% of your investment in a bad year, but fortunately, that doesn’t happen very often.
The percentages in this simple illustration aren’t set in stone. These are just rough numbers based on the last 50 years. You could lose more or less than these estimates, but the idea here is to inform you of what can happen—and what will happen from time to time. If you invest in any investment category for a long enough period of time, you should experience some losing years with losses that are comparable to this illustration. However, most people in the investment community generally say that if you hold on to a quality investment for a long period of time, you should earn a good rate of return. No one can guarantee this, but this seems to be the way that things generally work.
If you do not want to expose yourself to any risk, then your safest bet is to invest in government bonds. These pay the lowest rates of return, but they are the safest investments. The next safest investment would be in term deposits from your bank or credit union. An important concept to be aware of is that no investment is without risk. Governments can collapse or lose investor’s confidence, banks can fail, and companies can go bankrupt. When it comes to investing money, there is truly no such thing as a safe investment. Every investment has risk. Some investments have very low amounts of risk compared to others, but no investment can be called completely safe.
In the business world, risk is measured by credit ratings. The better credit rating a business has, the less risky it is perceived to be. Governments usually have the best credit ratings because if they need more money, they can either raise taxes or print more. Large banks are often next in line with the next best credit ratings, and then credit ratings move down from there. Below is a table that illustrates how credit ratings generally compare among different organizations. You will notice that the better credit rating an organization has, the less interest it has to pay to attract people’s investments. Everybody knows that there is less risk involved in investing in Government of Canada bonds than there is in investing in bonds of public or private companies. Credit ratings reflect this knowledge and so the Government of Canada doesn’t have to offer investors as much interest as a company would because investing with the government investment involves less risk than investing in a company.
|Expected Rates of Return based on Credit Ratings (objective measure of risk)|
|Organization||Rates of Return|
|Government of Canada||Pays the lowest interest rates because it is the safest place to invest|
|Large Banks||Pay higher interest rates because they are not as safe as the Government|
|Smaller Banks & Credit Unions||Offer higher interest rates because they are technically not as safe as the larger banks|
|Companies||Need to pay higher interest rates because they are usually not as safe as Banks or Credit Unions|
|Small business and Individuals (Family, Friends and Acquaintances)||Highest Risk (Banks use credit scores to assign credit ratings to individuals).|
When it comes to people investing their money, many people think that their risk tolerance is higher than it actually is. Most reputable investment companies and investment professionals know this, and so before you invest with them they will use a number of methods to confirm your risk tolerance to make sure that you aren’t making a choice that you will abandon at the first sign of trouble. If you say that you can handle a 15% decline in your investment, and then you want to get out of your investment as soon as it goes down 5%, no one will benefit. You will lock in a 5% lose and the person who is helping you with your investments may lose you as a client.
Make sure that you will be able to sleep will at night with the investment choices that you make. A good investment professional should be able to help you with this, or you can do some thorough research into your investment choices to put your mind at rest.
Here are some final thoughts on risk
- Never invest money that you can’t afford to loose.
- If something seems too good to be true, it usually is.
- Always consider what the worst case scenario could be with every investment decision that you make. The riskier the investment you choose, the higher the odds are that a worst case scenario will occur, and you will lose a lot of money.
- Don’t put all of your eggs in one basket. Make sure that you diversify your investments.