What Every New Investor Should Know About Risk
Published on August 31, 2017
One of the biggest fears people have about investing is losing their hard-earned money. Why take the risk when you could keep your cash safely stored in your checking account?
Well, a lot of reasons. For one, limiting the risk you take limits your returns. And when it comes to your biggest financial goals—like retiring someday—maximizing your returns is going to help you get there faster.
Yes, it’s smart to be concerned about risk, but it’s also smart not to let fear paralyze you. Investing is all about understanding risk, knowing how much you’re prepared to take, and choosing the types of investments that are right for you accordingly.
Here’s what you need to know.
Higher Risk, Higher (Expected) Return
The most important thing to understand about risk is something you’ve probably heard before: The higher the risk of your investment, the greater return you should expect on your money. (It is, however, the nature of risk that the return you expect might not be the return you actually get.)
The concept of “Modern Portfolio Theory” emphasizes that risk and reward are linked. If you hope for a higher return, you should also expect a higher volatility—the variability of actual returns. The returns on an S&P 500 ETF may be up one year and down the next. Returns on a mutual fund of Brazil stocks will likely have much wider changes in returns from year-to-year, or even month-to-month. You might make a lot more money, but you also could lose much more.
How Much Risk Should You Take?
When choosing a risk level, you want to first look at the goals you have (buying a house, saving for college, and retiring, to name a few), as well as how many years will it be before you need the money for each goal. That’s called a “time horizon.” Generally speaking, the longer the time horizon, the more risk you can afford to take, because you have more time to recover from market downturns. This is why young people are advised to put their retirement savings in a more aggressive portfolio—there’s a lot of time to go! As you get closer to retirement, you’ll generally want to be more conservative.
What Types of Risk Are There?
There are several types of risk that every investor should be aware of: market, business specific, price volatility, interest rate, and concentration—to name a few. Some risks you can’t avoid, like market risk. The market goes up and down, and this often affects all stocks.
You can, however, reduce other risks. For example, if you buy individual stocks, you open yourself up to business specific risk. Think Worldcom or Enron. But, if you buy an S&P 500 index fund, you are buying stock in 500 companies. If one of these companies falters, it will impact the S&P index, but it won’t have the same harsh impact on your investment.
How Should You Manage Risk?
How do you use these concepts to manage your investing risk? SoFi Wealth provides five levels of risk you can choose. Each one is a different mix of asset classes called an “asset allocation.” Each asset allocation attempts to find the mix of asset classes that produces the highest expected return at each level of risk. The trick is finding the one that best matches the time horizon for your goals.
Here is an example of the “Moderate” asset allocation in SoFi Wealth, which you might use for a medium-term goal.
It has 52.5% stocks to give you potential growth, but 47.5% bonds to reduce the price swings of the stocks and still give you interest income. This might be appropriate if you have a medium term goal, like buying a home or a child’s education starting in 4 to 7 years, or even when you are approaching retirement or in its early years.
Alternatively, here is an “Aggressive” SoFi Wealth portfolio intended for a time frame of 8 years or more.
It has 100% stocks to maximize growth potential. If you are a younger person saving for retirement, this might be a good choice for you. You should expect this mix of assets to have much wider value swings than the first portfolio. While it will probably appreciate more in up markets, it will also drop more than the other portfolio when the market goes down.
Note that if that is going to freak you out—and cause you to sell everything and hide your money under your bed—this is not the portfolio for you! Be honest with yourself. Over time this portfolio is more likely to have a higher return than the other one, but only if you stay invested through the bad times as well as the good. If that isn’t you, no problem—just pick a less risky asset allocation.
In investing as in life, you need to take risks to move forward. The key is to understand the nature of the risk, don’t take risks that you can’t afford, then take steps to mitigate risk and still reap the benefits. Think about it like driving a car. It’s risky, but you understand that risk and mitigate it by maintaining your car, obeying traffic laws, and buying insurance. The return is that you get where you’re going faster.
There are no guarantees in investing, but you can you make an informed choice of the amount of risk you are willing to take and invest intelligently to reach your goals.
Not sure what the right investment strategy is for you? A SoFi Wealth account makes it easy: Our technology helps you determine the right asset allocation mix for you, while advisors are available to offer you complimentary, personalized advice. Consider working with a SoFi Wealth advisor today.
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