How Do I Calculate Risk When Managing My Finances?

The concept of risk-reward is a rather simple and widely known concept. Anytime you invest money into something, there is a risk, whether large or small, that the investment may fail and you may not get your money back. For bearing that risk, you expect a return that compensates you for any potential losses. As a result, to put it simply, the higher the risk the more you should receive for holding the investment, and the lower the risk, the less you should receive. However, many individual investors do not understand how to determine the appropriate risk level for their portfolios. In this article, I provide a general framework that any investor can use to assess their own personal risk level and how this level relates to different types of investments.

Determining Risk Tolerance

With so many different types of investments to choose from, how should an investor determine how much risk they can handle? This is not a straightforward question and every individual is different. While it is hard to create a robust model that is applicable to everyone, here are two important things you should consider when deciding how much risk you can tolerate:

• Time Horizon: Before making any investment, you should always determine the amount of time you have to keep your money invested. If you are investing money today, but expect to need it in 12 months time, choosing higher-risk stocks for example, may not be the best strategy. The riskier an investment is, the greater its volatility is. So if your time horizon is relatively short, you may be better served investment in safer options.  However, with a longer time horizon, investors have more time to recoup any possible losses and are therefore more tolerant of higher risks.

• Budget or Bankroll: Another important factor in determining your risk tolerance is to clearly establish how much money you can stand to lose. While this might not be the most optimistic method of investing, it is the safest and most realistic. By investing only money that you can afford to lose or afford to have tied up for some period of time, you will be pressured to sell off any investments because of panic or any liquidity issues. As a result, you will be better off in the long run.

Investment Risk Pyramid

After deciding how much risk is acceptable in your portfolio by using your time horizon and budget as a framework, using the risk pyramid approach for balancing your assets is a great option. This pyramid can be thought of as an asset allocation tool that can be used to diversify your portfolio investments according to the risk profile of each security. This pyramid has three distinct tiers:

• Base: This segment of the pyramid represents the strongest portion of the structure, supporting everything above it. This area should consist of investments that are low in risk and have foreseeable returns and should comprise the bulk of your assets.
• Middle: The middle portion of the pyramid should be made up of medium-risk investments that offer a stable return while still allowing for capital appreciation. While these assets are riskier than the assets at the base of the pyramid, these investments should still be relatively safe.
• Top: This portion of the pyramid should be the smallest area of your portfolio and is reserved specifically for high-risk investments, and with money that you can lose without any serious repercussions. Importantly, money in the section should be fairly disposable so you do not have to sell prematurely in instances where there are larger capital losses.

Conclusion

At the end of the day, not all investors are the same. Some may see risk as an opportunity for great returns, while others may be more concerned that they may be left with nothing.  Regardless, it is vital for investors to understand the concept of risk. Making informed investment decisions necessitates not only making informed decisions on individual securities but having a strong understanding of your own finances and your own risk profile. To maximize returns while maintaining suitable levels of risk tolerance, investors must know how much time and money they are willing to invest and what type of returns they are seeking.