Recognising Risk
What is risk?
Very few investments are risk-free. Investing in stocks, in particular, means accepting some level of risk. Risk is simply the probability of losing money on an investment. A more technical definition of risk is the volatility of return on the investment. An asset with erratic returns is considered to be riskier than an asset whose value stays rather static or moves slowly.
Risk and return
If you want to make a killing in the stock market, you are going to have to take risks. If you keep all your life savings in safe investments such as a savings account, you will face virtually no risk and have some peace of mind, but your return will be low and inflation will make your initial deposit less valuable over time. There is a trade-off between risk and return. Less risk means less return, while taking on more risk brings the possibility of a higher return.
How much risk can I take?
This depends on various personal factors.
- Tolerance
Ask yourself how much you are prepared to lose over one year without giving up on your investment.
- Age
Younger investors can usually afford to be more aggressive.
- Investment goals
If you are saving to buy a house or starting to invest for retirement, you will need to invest in growth stocks. This means taking on more risk.
- Time horizon
You should have a good idea of when you expect to cash in your investment. The longer you can afford to wait, the less risk is involved. Do not invest in risky assets if you may need funds in the short term.
Currency risk
If you invest in foreign investments that are denominated in foreign currency, you will also face currency risk.
The important thing to remember is that you can never consider foreign investments in isolation from their currency denomination.
Example of currency risk
Let us say you invested the equivalent of US$10,000 in a US stock and made a four percent gain in three months. You would be sitting on a paper profit of US$400. But if, for example, the US dollar declined by six percent in value relative to your domestic currency over the same period, the equivalent paper loss would be $600, leaving you with a net loss of $200.
Of course, it could just as easily happen that the US currency increases in value by the same amount over the same period, giving you a 10% net gain, or $1,000.