Risk sometimes seems like a two-sided coin. On one side, you have acceptable risk, which provides opportunity for growth. But on the other, you have unacceptable risk that is accompanied with the potential to lose money.
Unlike a coin, you don’t have to choose a side. Learn to distinguish between different types of risk — and how to try and balance them. Then put your knowledge to work so you can invest your money with confidence and with a level head.
How Risk Can Be Acceptable
Some people think risk should be avoided at all costs, but that’s not always the case. Acceptable risk may potentially help your money grow, so you can be better prepared for the future. It’s all about balancing it against risk you’d consider unacceptable.
Accepting financial risk may lead to greater return.
As an investor, you accept some level of risk. Whether you invest in Exchange Traded Funds (ETFs) or purchase individual securities, you could lose your entire investment if it experiences a sharp downturn. But you may also create an opportunity to build wealth. That’s because there’s potential to make a greater return than if you simply put your money in an interest-earning deposit account at your bank, for example.
Financial risk may help you achieve your goals.
When you take on debt for student loans or a mortgage, you risk the possibility of not being able to pay it back. However, educational degrees and homeownership can open doors. You may score a job you love at a higher salary after graduation or build equity and raise a family in your dream home.
Saving and planning for your future are investments worth making, and the return you get may be worth the amount of risk you assume, although that’s not guaranteed.
How Risk Can Be Unacceptable
Risk without moderation may be dangerous. Taking on too much can put yourself in a vulnerable position and negatively impact your financial goals and other aspects of your life.
You risk more than you can afford to lose.
If you find yourself investing a large amount of money in a trend you saw on social media without doing your own research or bending to financial peer pressure to score a quick win, you might be pursuing unacceptable risk. By putting all your eggs in one basket, so to say, you could lose your entire investment if its value drops suddenly. Instead, you may consider building a diversified portfolio to help keep you steady as the market swings.
You put your future goals out of reach.
Assuming some amount of debt may be healthy for your financial well-being. For instance, having a mortgage versus paying cash for a home may potentially give you the opportunity to invest and save for the long-term. In contrast, high-interest debt like credit card debt can accumulate quickly and bury you under a burdensome amount of debt that you’re not able to pay back. It could jeopardize your credit score and make it more difficult to be approved for a mortgage or qualify for a personal or student loan later on, putting home ownership or other dreams out of reach.
How to Use Risk When Investing
When you take on a healthy amount of risk, your money may have more opportunities to grow. Use these steps to help you determine what the right risk-reward balance is for your situation:
1. Determine your risk tolerance.
Ask yourself these questions:
- How much are you willing to lose before you cut your losses when trading?
- What amount of risk makes sense for your investment goals?
Once you identify an ideal risk level, you can take on intentional risk with stocks, bonds and ETFs that fit your level of comfort.
2. Consider your stage of life.
For many investors, the younger you are, the more risk you can take on. If you don’t plan on tapping into your investments until you retire, there’s more time to recover from occasional market dips. But if you need money in the short term, you might be better off sticking to more conservative investments. As always, it depends on your situation and the level of risk you’re most comfortable with.
3. Look at history.
If you want to better understand the risk associated with a particular investment, look at its history. Maybe it’s performed steadily for the past 10 years, or it might have a pattern of declining and recovering quickly. This information can help you decide if the investment makes sense for your financial goals.
4. Think long-term.
To ensure long-term financial security, you may want to avoid risk that includes an unhealthy amount of debt or that is completely vulnerable to market volatility. Be sure to balance investing in the market with building an emergency fund and finding a budget method that works with your lifestyle.
No Risk, No Reward
Risk may be a tool to help you generate wealth, and to be financially successful, you may find that you need to assume some level of it. It may be a bigger financial risk to not assess your risk appetite and investing strategy at all. So, select a risk amount that is comfortable to you, and you’ll be able to approach investing with a more confident mindset.
Invest the way you want.