Ready to start investing? One of the most challenging concepts to grasp when starting out is risk management - understanding how much exposure to risk you can afford (and are comfortable with taking on), and how to use risk to increase your profits.For first timers, this can be absolutely overwhelming. Here's how to assess what you can take on, and what's too risky.
Types of Investment Risks
When it comes to investments, there are six types of risk to consider:
- economic
- industry
- inflation
- credit
- market
- tax
If the economy suffers a downturn, as it did in 2008, financial markets are usually affected. The economy itself may not take a hit, but specific industries within it might. For this reason, it’s important to know the industry into which you’d like to invest, and how vulnerable it will be to recession.
Next, you’ll want to consider inflation risks. For instance, the long-term value of an asset, such as a GIC, might not keep up with inflation if it rises too quickly. If an investment issuer doesn’t live up to its financial obligations, it’s always possible to lose the capital you’ve invested. This is known as a credit risk.
Unfortunately, there are no guarantees that your investments will increase in value. In fact, there’s always the possibility that it will decline in value instead. This is known as market risk. Finally, there are tax risks to consider. Rising taxes can mean fewer funds to go around for investors.
For the least amount of risk, try investing in GICs. Their security is ensured, and the only risk you face is inflation risk.
What’s Your Risk Comfort Level?
Although no investment is without risk, some are less risky than others. Your ideal investment will strike the balance between risk and reward. To do this, you need to determine your risk comfort level. To do this, consider the following:
- Age
- Income
- Debt
- Family
- Long-term financial goals
How To Assess Your Risk
Consider the following questions as a general guideline for calculating your risk limit. With that in mind, give yourself 1 point for every A, 2 points for every B and 3 points for every C.
How old are you?
A) 41-65
B) 25-40
C) 16-24
Are you employed?
A) Yes
B) Somewhat. I work part time.
C) No
Is your job steady?
A) Yes, I’ve been at my current job for years.
B) I’m fairly new to my job, but I’m planning on staying.
C) I’ve lost three jobs this year, and just started my fourth.
How much money do you make?
A) I never worry about my bills and I have ample savings.
B) I pay my bills on time, have some debt, but not enough in savings.
C) I don’t know how I’m going to pay my rent this month and my phone has just been cut off.
How much debt do you have?
A) I have almost paid off my mortgage and owe on a line of credit.
B) I have a car loan, a student loan, a small amount in credit card debt and a mortgage.
C) I’m currently in collections for credit card debt and have defaulted on my student loan.
Do you have any dependents? (If yes, add 1 point for each one)
A) No
B) It’s just me and my partner.
C) I’m in a relationship and we have children.
What are your financial goals?
A) I’d like to save for my child’s education, set aside a substantial amount in savings and be debt-free by 55.
B) I’d like to be debt-free and retire by 65.
C) I hope to win the lottery and travel the world.
How’d you do?
7-11 points: You’re as low-risk as they come.
12-17 points: Exercise caution and don’t bet the farm.
18+ points: You’re about as risky as running a red light during rush hour.
