There are beginner investors who can’t wait to invest or do a deal. They want to put capital to work right away and see the returns. On the other end of the spectrum, there are investors who hesitate to invest as they fear losing the money. And then there is a wide range of investors in between.
So, with this wide range of investors, where does one start? We’ll argue in this article that the first step to start investing is to understand risk, our tolerance to risk, and our goals. Understanding ourselves, our motives, and behavior is probably the hardest and most time consuming for many beginner and intermediate investors. In this post, we’ll share key steps with some resources for investors to assess their personal risk tolerance and create investing goals.
Where does an investor start?
Remember the first time you built a hobby? It probably happened over months or years. You tried a few things, liked that particular activity, and started doing more and more of it. Consciously, you may not have even taken the time to observe our actions. But, but you enjoyed it and continued it. Though many won’t consider investing as a hobby, the journey is similar. There is a lot of learning involved – technical and behavioral – and it is a very long journey to get better at investing. What is the first step in this journey? It comes down to understanding risk and our tolerance for risk. In the first place, what is risk?
In simple terms, risk is the possibility of something bad happening……
Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value…such as health, well-being, wealth, property, or the environment…. often focusing on negative, undesirable consequences.Source: https://en.wikipedia.org/wiki/Risk
It is easy to get carried away in this day and age as most of us are exposed, sometimes overexposed, to finance and investing from general and financial media? We maybe seduced to get stock tips from our favorite financial media or guru and act on it. We need to be careful. Investing is not speculation and is for the long-term, and patience and learning are key. A good investor learns the basics and continues to learn every day!
Understanding and having an appreciation for risk is at the heart of finance and investing. Reward or returns is a by-product of risk. Many of us focus on rewards without appreciating the underlying risk. We’re always enticed by the higher return. But, we need to start with understanding our risk tolerance as explained below.
Evaluating our personal risk tolerance
We take risks on a daily basis though we may not see it as such. We make decisions based on risk all the time. Every time we cross a road we assess and take the risk of safely crossing the road. We select a college and course after weighing the risks and rewards. Will this college help me secure a job? We may not see it as such but some of the major life decisions are also risk-based decisions:
Given the importance of risk in finance and our daily lives, understanding our individual risk tolerance is of paramount importance. This will save months and years of worry and regrets.
Let us take an example. Say, you’ve $1000 to invest and are looking for ways to invest. You have done your research and narrowed it down to 3 options. The first option will give $10 after a year, but $1000 most likely not get affected. The second option will give you $100, but you could also lose $100 and end up with $900. i.e. Option 2 is riskier than Option 1. Some may prefer Option 1 and some may prefer Option 2. There is no universal single correct answer. It depends on the individual. It is important to understand which option you prefer i.e. what is your risk tolerance.
FinYork recommends taking an Investment Risk Tolerance Assessment, as the first step in assessing investment risk tolerance. The one below from the University of Missouri is popular. It is worth every minute of your time as this will set the stage for your investment planning.
Once you finish answering all the questions, you’ll be given an assessment of your risk tolerance. You can use this as the basis of your investments or discuss it with your financial advisor. You may have seen your brokerage’s investor profile questionnaire which is another tool for individual risk tolerance assessment. The whole purpose of this exercise is to evaluate your individual risk tolerance and even confront your fears upfront.
The survey gives a risk tolerance score at the end as shown below. The score will indicate whether you have a HIGH, MEDIUM or LOW risk tolerance. Your investment strategy has to follow your risk tolerance level. For e.g. someone with a LOW risk tolerance should go with a conservative investing strategy and invest in less risky asset classes. We’ll cover this in detail in upcoming articles.
We have so far looked at evaluating our risk profile and risk tolerance. Once we have an idea of our personal risk tolerance, what do we do next? The next step is to set up investing goals which will form the basis of our personal investing approach. If you already have investing goals and approach to meet those goals, that is great. If you don’t, please take the time to write them down. You need to make sure that you don’t stop at personal finance and budgeting but also think about your net worth and investing goals with a long-term view. You’ll find it beneficial to evaluate where you’re today in terms of personal finance (income/expenses) and net worth.
Investment Goals will differ by age and personal situation
Investment goals for people in their 20s are quite likely different from people in their 40s or 60s. Similarly, goals for people with families are going to be different for singles or couples. More importantly, they are going to be different based on your risk tolerance and personal financial situation. Please take note of your work situation, financial cash flows when coming up with goals. It is best for goals to follow the SMART method of setting goals. For further reading, please visit Corporate Finance Institute’s site on setting up SMART goals.
Write down Investing Goals
Before we get into the how of investing, particularly real estate investing, it is very important to assess your risk tolerance and have clear investing goals. Please take the time to write down the investing goals even if it takes a few hours a day. Above all, investing is a habit. You need to be committed and keep practicing it consistently to get better at it. Your investing goals may consist of the following or more:
- Your goals and why you want to achieve those goals? For e.g. “My goal is to retire by 55 with X income and Y assets so that I can be financially free”
- What are your guiding principles? For e.g. “I will invest in companies that also do some social good”
- Your fears and how to overcome them? For e.g. “My fear is that I have little confidence in myself when it comes to money matters. I plan to overcome my fear by learning about investing by spending an hour every day.”
In this article, we understand the basics of risk and risk tolerance and why understanding our risk tolerance is so important. Risk and our tolerance of risk is in itself not a good or bad thing. We just need to understand our risk tolerance as this will define our investing strategy. Having a true appreciation of our risk-taking will define our investing strategy. It will lead to the kind of investments – stocks, real estate, etc. we chose. We hope we’ve convinced you as an investor to evaluate your risk tolerance before making your first investment as it will save a lot of headaches.
Complete the above-referenced questionnaire, evaluate your risk tolerance, and keep it for your reference. In addition, take the time to think through and write your Investment Goals. We suggest doing this exercise on a regular basis (say, year-end every year) as that will inform us of our risk tolerance and come up with an appropriate investment strategy to manage risk. This will be the topic of upcoming articles.