You might be familiar with the risk-reward concept, which states that the higher the risk of a particular investment, the higher the possible return. But many investors do not understand how to determine the risk level their individual portfolios should bear. This article provides a general framework that any investor can use to assess his or her personal risk level and how this level relates to different investments.
This is a general concept underlying anything by which a return can be expected. Anytime you invest money into something, there is a risk, whether large or small, that you might not get your money back. In turn, you expect a return, which compensates you for bearing this risk. In theory the higher the risk, the more you should receive for holding the investment, and the lower the risk, the less you should receive.
For investment securities, we can create a chart with the different types of securities and their associated risk/reward profiles.
Although this chart is by no means scientific, it provides a guideline that investors can use when picking different investments. Located on the upper portion of this chart are investments that have higher risks but might offer investors a higher potential for above-average returns. On the lower portion are much safer investments, but these investments have a lower potential for high returns.
Determining Your Risk Preference
With so many different types of investments to choose from, how does an investor determine how much risk he or she can handle? Every individual is different, and it's hard to create a steadfast model applicable to everyone, but here are two important things you should consider when deciding how much risk to take:
Investment Risk Pyramid
After deciding how much risk is acceptable in your portfolio by acknowledging your time horizon and bankroll, you can use the risk pyramid approach for balancing your assets.
This pyramid can be thought of as an asset allocation tool that investors can use to diversify their portfolio investments according to the risk profile of each security. The pyramid, representing the investor's portfolio, has three distinct tiers:
The Bottom Line
Not all investors are created equally. While others prefer less risk, some investors prefer even more risk than others who have a larger net worth. This diversity leads to the beauty of the investment pyramid. Those who want more risk in their portfolios can increase the size of the summit by decreasing the other two sections, and those wanting less risk can increase the size of the base. The pyramid representing your portfolio should be customized to your risk preference.
It is important for investors to understand the idea of risk and how it applies to them. Making informed investment decisions entails not only researching individual securities but also understanding your own finances and risk profile. To get an estimate of the securities suitable for certain levels of risk tolerance and to maximize returns, investors should have an idea of how much time and money they have to invest and the returns they are seeking.