By Kevin Judge | May 31, 2019
Every person has their own view and tolerance of risk. This is a critical fact in determining their investment strategy and each investor needs to have a clear understanding of what level of risk is appropriate for them and act accordingly.
- Some people are by nature risk averse and will only invest in risk free or low risk investments.
- For example, Government Bonds, Banks Deposits, and AAA investments.
- Other people are risk takers and will take extreme risk hoping for high return. Literally gambling, enjoying the game of risk!
- They will purchase risky investments, such as junk bond or penny stocks and use risky strategies such as buying on margin and naked options.
- A rational investor will vary their risk tolerance based on scenarios that are driven by several factors:
- How important is it to you to achieve the investment goal?
- How soon must you achieve the investment goal?
- How much of the investment can you afford to lose in a worst-case scenario?
Risk Driven Scenarios
| Risk Level | Example Scenario |
Investment Goals for Scenario |
Appropriate Investments and Recommendations |
| Little or none | You need money in the near future ( <1yr) to make a major purchase, such as down payment on a home or paying cash for a car. |
|
Savings Account, Bank CDs, Money Market Funds, US T-Bills.
Recommendation: Any of the above, but for CDs and T-Bills make sure you pick the best due date |
| Moderate | You are saving for retirement. |
|
Mutual Funds are a great investment in this scenario, and investment accounts like 401ks often allow you to choose among a variety of funds with different asset classes and objective. Each fund has diversified portfolio and you select a diverse group of funds, all reducing risk.
Recommendation: Pick a diverse group of mutual funds with varying levels of risk. For example, spread your money across a Growth Stock Fund, High Yield Bond Fund, Real Estate Fund and an Emerging Markets fun |
| Moderately High | You have some money that is not needed in the immediate future outside of retirement planning |
|
Mutual Funds can be a good investment because you can pick ones with higher levels of risk, but still have safety in diversification.
Direct investment in stocks and bonds may be appropriate with bonds less risky than stocks. Recommendation: I would recommend stocks in companies that at least meet the following criteria:
|
| High | You have a windfall that you did not expect and can afford to lose. |
|
Anything can be a high-risk investment if you are heavily leveraged and use naked options and short sales
Investments that have high risk, but can high returns include:
Recommendations Most people should stay away from these strategies, but if you do you must do your homework and monitor the investment closely. Critical to success is to have an “exit strategy” and a trigger to cut your losses or cash in. |