Modifying Your Risk Tolerance
Recognizing common mistakes in approaches to investing is a good starting point in determining how not to approach stock and options investing. All of the mistakes involve perceptions or misperceptions about the markets, but they all share a common element: a perception about risk. If you can identify risk levels to a particular strategy and quickly decide whether they are good matches for your own risk tolerance, you will be far ahead of most other investors and traders. Risk exposure is the central determining test for every investing strategy you will consider.
Your ability and willingness to be exposed to risk is a matter of degree.
Smart Investor Tip
Risk tolerance is an ever-changing matter, reflecting your attitude, experience, knowledge, and resources at the moment. It will be different next year and the year after, so you need to review risk tolerance constantly.
Capital resources and income define your ability to undertake certain risks. If you have a large amount of capital to invest, you will be able to consider a wider array of possible investments than if your assets are more limited. Of course, that also means that you will likely be unaware of the risks associated with some decisions. Having a large amount of capital available might contain risk of its own in that regard; so if you inherit a large sum of money, sell your house, or take other actions that bring you a large nest egg to invest, you need to still pay attention to risk. The same arguments apply to income levels. An individual with a comfortable level of income will be more inclined to diversify in terms of investment products and risks. As a strategy, it makes sense to vary the risk levels of your portfolio as long as it is part of a plan. The danger arises when risks come about unexpectedly.
Investing experience has a lot to do with the risks you take on and how you evolve as an investor. As you become familiar with options, for example, you will be willing to try advanced strategies, use options in different ways within your portfolio, and diversify risks with option positions. Experience has another side: those who have lost money in the market learn about risk the expensive way. Many people walk away from the market permanently, which is a risk decision. They conclude that the market is simply not a safe investing environment. In fact, it can be, if you learn how to mitigate specific risks.
Family status has a lot to do with the types of investments you choose. If you are a young single person making good money, you will be inclined to take greater risks; if you are married, buying a home, and raising young children, you will by necessity think about security, college education expenses, and retirement savings. Major events, like marriage, birth of a child, divorce, losing a job or starting a new career, relocating, health problems, or the death of a loved one, will understandably have a major impact on how you invest, because such events change your risk tolerance profile.
Condition of the market will also change your risk tolerance. When the market is going through a broad-based bull period, it is easy to feel confident about investing. As a result, there is a tendency to lower your observation. In these conditions, it makes sense to buy and hold securities as long as the good times last; but at the same time, be aware of risks. Markets can turn around quickly.
Smart Investor Tip
Even recognizing the fact that markets change continually, it is easy to make the mistake of fixing your definition of risk and never changing. As a consequence, your profile can become outdated.
Personal attitude will have more to do than anything else with your definition of risk tolerance. If you consider yourself ultraconservative, you will prefer to leave the majority of your portfolio in low-yielding, insured money market accounts. Others can tolerate high risk and seek the best possible returns and will speculate in long-shot investments. Most people are somewhere in between.