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Financial Risk Management – Know What You can Tolerate

financial management
Source: stck.xchng Photo: mzacha

One of the issues that has come up recently is whether or not to get into buying stocks. On one side are the investors that swear now is the time to take advantage of the investment bargains. On the other side are those who think that it’s time to get out of the stock market — ideally, two months ago. Where you fall on this issue largely depends on your long-term view of stock picks as compared to other investments. It also depends on your investment risk tolerance.

Risk tolerance

Financial risk management is vital to a healthy portfolio. As you might guess, risk tolerance is a reflection of how much risk you can handle in terms of investing. Some people have a higher risk tolerance — and can better handle the possibility of loss — than others. However, there is a little more to risk tolerance. Risk tolerance can be broken down into two main categories:

  1. Financial risk tolerance measures how much risk you are financially capable of taking on, according to your money situation. Financial risk tolerance is a fairly straightforward assessment of what you can handle. Can you afford to put that money in the stock market and not use it for at least five years? Would losing the money you put into an ETF financially devastate you? This principle even works when you consider buying a home or making some other type of expenditure that requires a financial commitment and possible risk. Financial risk tolerance is running the numbers and figuring out how much risk you can afford. It’s a reasonably objective process that is difficult to argue with.
  2. Emotional risk tolerance, though, is purely subjective. It deals more with your visceral reactions to what is going on. You might have enough money to invest $2,000 in a stock, but if you are extremely concerned about everything that is going on right now, you may not be able — emotionally — to handle the stress involved in watching the losses mount until the market pulls out of its tailspin. Your emotional risk tolerance speaks to the level of distress you feel when making investments. Venture capitalists generally have a very high emotional risk tolerance: They can handle the uncertainty that comes with risky investments, and they can recover emotionally when things don’t work out as they expected. Your level of emotional risk may however vary with the economic ups and downs as well as your financial situation.

Finding a Balance

The key is to create an investment strategy that allows you to grow your money in a way that you can afford, while at the same time not causing you undue emotional discomfort and stress. Worry is a natural part of investing, but you should not commit to investments that cause you unhealthy levels of stress. If the thought of currency market or futures market volatility makes you ill, or if you can’t afford the potential losses that come with heavily leveraged investments, stick to stocks, funds and cash.

It is important to note that risk management encompasses a partner relationship as well. You and your life partner should discuss risk tolerance and what you are comfortable with. Investment decisions should be made together, and you should compromise between your risk tolerance levels. If you have a high emotional risk tolerance, but your life partner doesn’t, you may have to find some middle ground. It can strain the relationship if one of you becomes stressed over potential investment loss.

Managing your investment risk

In some cases, you may need to accept a little more risk in order to grow your wealth. In such cases, you can temper your emotional response to risk with a balanced portfolio or with investments that carry different levels of risk. Mutual funds and index funds add diversification that can help mitigate some (but not all) of the financial risk with investments. Separately managed accounts also provide opportunities to experiment with different levels of investment risk. An emergency fund, or large savings, can also help provide peace of mind when there is concern with regard to investments.

Carefully assessing your options and making a plan that take into account your risk management profile can help you become a more effective investor.

5 Responses to Financial Risk Management – Know What You can Tolerate

  1. Ah, the risk reward comparison. I think it’s always easier to invest in long term stocks if you first have a sound emergency or savings fund. When asked by friends how they should invest $500, I first ask if they have 6 months set aside in savings.

  2. I imagine many of us will be “risk shy” after losing so much of our 401ks. My CD and savings account interest is so awful, though, it’s hard not to introduce some risk into my life- even in today’s scary market. They keep saying it’s going to break. I hope so…. I’ve bought a couple of stocks low, with part of my savings – above what I have put aside for an emergency – about 6 months worth of money, like the Passive Ddad suggests, too.

  3. Scott, yes, an emergency fund is essential although there is no reason why it should be in low yielding cash accounts. Buying a good money market fund or a short term bond fund does not introduce a lot of risk in a portfolio and should be one of the choices.

    Lisa, it is human nature to be fearful when you should be greedy and that is what undermines the performance of most individual and even institutional portfolios. As long as you have a backup in the form of an emergency fund, it is always wise to buy a good selection of securities when everyone else is selling. Congratulations on your stock purchases! It was a tough but right decision to make.

  4. It’s all about balance. You do have to introduce SOME risk into your portfolio to see any growth. The good news, though, is that over time the stock market gains, so your 401k is likely to recover to some degree. And I agree with Scott that it is easier to take a little more risk when you have a safety net to fall back on. I like the idea of bond funds or even a CD ladder to boost yields a little bit in this area.

  5. It’s still very risky out there at the moment, look at all those people who bought back into Goldman Sachs, the whole thing devalued the shares massively. If you have money to spare then a few risks now and then are acceptable, but sometimes you don’t always get out alive and that’s the risk you take.

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