Understanding Risk & Reward

Whenever you invest, there is a chance that your investment will not make money or, worse, will lose value or even become worthless. This potential for your investment to lose value is a concept known as risk, and how much of it you are willing to cope with as an investor is very important to the investment decisions you will make.

As an investor, if you expect a greater reward, then you need to be prepared to take on greater risk. The saying in investment circles is, “The higher the risk, the higher the potential return.”

Investing in a company generally carries a higher amount of risk than saving money in a bank account. After all, if the company does not do well, your shares may lose value or even become worthless, whereas when you save in a bank, you usually expect to get all of your deposit back. If both the shares and the savings account were offering the same reward, why would you choose the riskier option where you might also lose everything?

Investors may be willing to take on the extra risk involved with investing in shares, but only if they expect a better reward for doing so. Investing is a matter of balancing potential risk and reward. To do that, you take your next step which is understanding your risk tolerance.

Risk Tolerance

It is important for you as an investor to understand how much risk is appropriate for you. If you hire someone who is registered with the Commission to offer investment advice or to manage your securities, then understanding your risk tolerance becomes their responsibility too. How else could they recommend securities that are suitable for you?

There are a few things to consider when determining how much risk is right for you, including how you cope with risk emotionally, and what kind of financial position you are in to handle potential losses. Investment professionals often refer to these as risk appetite (emotional) and risk capacity (financial).

An investor’s risk tolerance may change as circumstances change over his or her life. There are a number of factors influencing this, including his or her age, income level, current wealth and health. For example, younger investors generally have a longer time to recover from investment losses and, as a result, generally can tolerate more risk than older investors.

The table below compares the risk tolerance that many investment advisors would say is appropriate for various age ranges, and the types of investments generally recommended based on the risk tolerance.

Typical Risk Tolerance Profile

Diversification

One approach that investors use to decrease their risk is to avoid placing “all their eggs in one basket” or, put another way, to “diversify” their investments. This strategy involves spreading your money among various investments in the hope that if one investment loses money or fails, the other investments will make up for those losses.