All the recent hype around Gamestop, cryptocurrency, non-fungible tokens (NFTs) and meme stocks got me thinking: anyone no longer risk averse?
Anyone appreciate a steady profit versus playing 50/50 to win big or lose it all?
Of course, I know the answer is yes. There are currently over $ 4 trillion in passive funds, which means that a lot of people are using a long-term investment strategy.
But still, it seems like everyone is playing with their hard-earned money as if they are in Vegas for the first time. And this is partly true.
While many people invest in index funds and other traditional investments, Dogecoin (a cryptocurrency that started out as a meme … yes, a meme) has a market cap of nearly $ 50 billion!
Ford doesn’t even have a $ 50 billion market cap.
When I felt the hint of FOMO surrounding all these fast-growing investments, it felt like a good time to reconsider why I am transferring these types of investments at all – because of the risk they carry.
Risk identification
According to Merriam Webster, definition of risk it is “the possibility of loss or injury.”
In this case, when dealing with the world of personal finance, we will focus on the first three words – possibility of loss… In particular, financial losses.
High risk investments has a high likelihood of a decline in value, resulting in a loss of money. High risk investments include things like stocks, NFTs, and cryptocurrencies.
Naturally a low-risk investment has a low likelihood of a decline in value. Low-risk investments include bonds and certificates of deposit (CD).
And then you have everything in between, like real estate.
While risk is not a binary measure … another variable to consider when determining risk is time…
The longer you hold an asset, the less risky it becomes (usually). For example, in any given year, the S&P 500 can rise or fall by 30%. So this is a rather risky option.
Over time, however, it becomes less risky. You can be relatively confident that the S&P 500 will average + 5-10% returns per year over most 20 year periods.
This is why when you are 20 or 30 years old and you are just starting to invest; it makes sense to invest in your own capital. You have a long time horizon over which to invest.
As you approach retirement and need money in the next few years, it probably makes sense to adjust your portfolio allocation towards more conservative investments. As your time horizon is shorter, investments generally become more risky.
Definition of risk aversion
Avoiding risk defined as risk avoidance. Pretty simple.
If you are a risk averse investor, you will be looking for investments with a low probability of a decline in value. This is because you value saving your money more than seeking the highest possible profit.
And, of course, the trade-off with a risk averse investor is that you don’t get insanely high returns on your money. Instead, you will receive smaller but stable and positive returns.
On the other hand, someone who is not afraid of risk gives preference to seeking the highest possible return over looking for a safe investment.
How to know how risk averse you are: ask yourself 5 questions
I designed a quick 5-question quiz to help determine your level of risk aversion.
There are subjective answers to some of these questions, while others are objective. However, they all help you figure out what level of risk you can take, which is good to know when building your own investment portfolio.
Question 1. How close are you to retirement?
- 0-5 years old
- 6-10 years old
- In 10-20 years
- 20+ years ahead
Question 2: How big is your Emergency Fund?
- I have none
- 1 month savings
- 2-3 months of savings
- 3+ months of savings
Question 3: Which of the following would you choose to generate a return on investment this year?
- Guaranteed yield of 3%
- 95% chance to get 7% refund (5% chance 0%)
- 75% chance to get 11% refund (30% chance 0%)
- 50% chance to get 25% refund (50% chance 0%).
Question 4: Have you ever bought a lottery ticket or gambled?
- Never
- Maybe once a year
- Occasionally
- Every chance I get, I love lotteries and casinos
Question 5: In general, would you say that you are good at money?
- To be honest, not really
- I’m fine – I have a basic budget and a good income, but I don’t save or invest as much as I would like.
- For the most part, yes. I save and invest at least 10% of my income
- Yes, I’m a money expert and I’m on my way to my goal of financial independence.
What do your results mean
Now add up your score based on your answers above. You should get a result between 5 and 20.
You can use the total to understand how risk averse or should you be when investing:
5-10: High risk aversion
You are a risk averse investor who is not afraid of lower returns and should seek conservative investments.
You are probably close to retirement and value safety over high profit potential. Bonds, certificates of deposit (CD) and interest-bearing accounts attract you with their stability and liquidity.
And while you don’t shy away from stocks in general, when you invest in them, they invest in low-cost and passive index funds. You can also seek help from a financial advisor or robo-advisor.
Your monetary mantra is to make a stable and predictable profit when looking for your own investments. Uncertainty is not your friend.
Typical investments:
- Bonds (including government bonds, treasury bills, corporate bonds)
- Certificates of Deposit (CDs)
- Savings account with high yield (with good interest rate)
- Money market funds
- Stock Index Funds and Exchange Traded Funds (ETFs)
11-15: Moderate risk aversion
You have an average to healthy risk tolerance.
You are probably good at managing your personal finances, but not a gambler. Although you invest the vast majority of your fortune in stocks, it is either in index funds and mutual funds or in a portfolio of dividend stocks that have the right level of diversification.
You will also likely balance your portfolio with a lot of stocks by investing a small portion of your money in bond funds. Of course, this is in addition to the cash in the reserve fund.
Typical investments:
- Stock index funds, exchange traded funds (ETFs) and mutual funds
- Diversified stock portfolio
- Real estate
16-20: Low risk aversion
You are not very afraid of risk and are not afraid to gamble if the expected return and potential payout are high.
While you can still invest primarily in the stock market, if you are risk averse, you also have a high likelihood of investing in cryptocurrency and even day trading stocks. This is because you are constantly looking for the best investment opportunities to maximize your return on your money.
However, this does not mean that you give up caution and take risks. Aggressive investors can still be smart and pragmatic. When you play and place your bets, you research and choose wisely.
The phrase “higher risk, higher reward” probably resonates with you.
Typical investments:
- Stock index funds, exchange traded funds (ETFs) and mutual funds
- Diversified stock portfolio
- Cryptocurrency
- Speculative stocks
Risk aversion: why it matters in personal finance
Understanding your level of risk aversion is a valuable step towards creating an investment portfolio that suits your needs.
After all, personal finance … personal.
Just because your neighbor, friend or work colleague invested in Gamestop back in March doesn’t mean you should be doing it too!
Likewise, just because someone only invests in index funds does not mean that this is the best strategy for everyone (although I think it is a good one!). It is best to make investment decisions based on your specific comfort level, situation and long-term plans.
And remember, a little risk aversion is great. This is what keeps you from flying to Vegas to put all your savings on red, to get a ~ 48% chance to double your money and a ~ 52% chance to come home with nothing (this is a roulette wheel guide for those who answered “never K question 4!).
However, you must remember that any investment comes with a certain financial risk. Thus, your goal should be to minimize this investment risk while still achieving the best possible results from your investment.
Like so much in personal finance, it’s all about balance.
This article originally appeared on Your Money Geek and has been republished with permission.