As published in the Racine Journal Times | May 3, 2013
As the stock market losses of 2008-2009 become a distant memory, it’s a good time for a refresher on the primary risk when it comes to investing, which is the unexpected loss of value.
There are three elements of identifying investment risk which are often confused with each other or lumped together. Before we address ea
Quite simply because the majority of us have a greater need for income than what our money can provide if it’s buried in the backyard or left in a savings account generating 0.01 percent interest. The only way to generate higher returns is to take more risk.ch of the elements, it’s worthwhile to ask why do we even want to take risk in the first place?
The elements of investment risk can be divided into the following concepts: risk required, risk capacity and risk tolerance. Risk required is based on the relationship between risk and return resulting in a specific amount of risk being required to generate sufficient returns to achieve your goals. For instance, if you need to earn 6 percent on your investments to satisfy your income needs, then moving beyond certificates of deposit is unavoidable in your portfolio. This element is dependent on your goals with a realistic understanding of what it will take to achieve them.
The second element is risk capacity. Think of this as worst-case scenario planning for your investments. Because we cannot predict the direction of the stock market, knowing whether there is room for unexpected outcomes is important in determining the amount of risk to take.
A great example is saving for college. There’s typically a specific point in time when the money is needed. Your child may not want to hear that they need to delay college for a year because there was an unexpected decline in the value of their college savings. Unless you have the ability to recover those losses through paying more from your income, you would have a low capacity for risk.
The final element is the one most often cited, which is your risk tolerance or psychological ability to take risk. Think of this as your comfort zone around wanting a positive outcome but also willingness to experience losses. While the previous two elements can be calculated with some degree of confidence regardless of your personality, risk tolerance is heavily dependent on the individual. Fortunately there is a scientific discipline for measuring your risk tolerance called psychometrics which looks at assessments based on the validity and reliability of the results.