Contents
What’s an Investment?
Risk and Risk Tolerance
Asset Allocation and Diversification
Should You Be Investing?
How to Get Started Investing
How to Invest in Stocks
How to Invest in Bonds
How to Invest in Mutual Funds
How to Invest in ETFs
Investing and Taxes
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Risk and Risk Tolerance
Before you begin investing, it’s essential to understand some of the basic principles of investing—namely, risk, return, volatility, and risk tolerance.
Investment Risk, Return, and Volatility
Risk refers to the uncertainty of an investment’s return. Some investments, such as savings accounts, have guaranteed returns and therefore carry no risk. Others, such as stocks, carry a lot of risk. The return on any particular stock is always uncertain: depending on the performance of the company, its stock could double in value, or it could become worthless. Volatility is the degree to which the value of an investment tends to fluctuate over time.
- Risk and volatility tend to correlate with investment returns: the higher the risk of an investment, the higher its volatility and potential returns.
Over short periods of time (five years or less), investments with high risk and volatility have the greatest chance of losing value. For instance, a stock worth $5 today might be worth $2 tomorrow. Over longer periods of time, though, investments with high risk and volatility tend to have a greater chance of increasing in value than low-risk investments.
Risk Tolerance
Risk tolerance refers to the amount of risk that you, personally, are comfortable accepting in your investments. To position yourself to benefit from your investments, you need to determine your risk tolerance.
How to Determine Your Risk Tolerance
Two important factors that affect your risk tolerance are your time horizon and your personal response to risk.
Your Time Horizon
Your time horizon is the amount of time you have before you’ll need the money you’ve invested. Time horizon has a direct relationship to risk tolerance:
- The longer your time horizon, the greater your risk tolerance since short-term changes in an investment’s value won’t affect you. Investors with long time horizons (10 years or more) generally have a high risk tolerance. These investors should usually invest for growth by buying stocks almost exclusively.
- The shorter your time horizon, the lower your risk tolerance since a short-term dip in the value of an investment might occur just when you had planned to use that money to finance a major purchase. Investors with moderate time horizons (5–10 years) generally have a moderate risk tolerance and should invest for growth and income by investing in stocks, bonds, and cash equivalents (such as certificates of deposit (CDs), which are almost always risk free). Investors with short time horizons (1–5 years) generally have a low risk tolerance and should invest almost entirely for income by buying bonds and cash equivalents.
The correlation between risk tolerance and age isn’t 100% ironclad. Other factors, such as your personal life situation and upcoming financial obligations, can have a major impact on your risk tolerance. For instance, a young couple saving to buy a home within the next five years might seem to have a high risk tolerance, based on their age. Even so, they should probably consider their risk tolerance low since they’ll need to use the money they’re investing to buy a home within five years.
Your Personal Response to Risk
In addition to the risk that you can accept based on your time horizon, risk tolerance also includes how you feel personally about taking risks and losing money.
- If you avoid risk in everyday life or worry easily: Even if you have a long time horizon, it still might be best for you to avoid buying risky investments such as stocks. Though your returns will potentially be lower, you’ll get the benefit of lower volatility and less stress.
- If you enjoy risk and don’t worry easily: You should feel comfortable investing for growth exclusively—assuming you have a long time horizon.
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