Define the risks and the risk hierarchy
You may be familiar with the concept of risk and return, which states that the higher the risk of a given investment the higher the potential return. But many individual investors do not understand how to determine the appropriate level of risk their portfolios should take.
This article from MarketsBloom provides a general framework that any investor can use to assess the personal level of risk and. how this level relates to different potential investments
The Risk and reward concept
Risk and reward is a general trade-off based on almost anything through which a return can be achieved. Anytime you invest money in something. There’s a danger whether it’s big or small. Don’t get your money back – investment fails. To take these risks, you expect a return that will compensate you for potential losses. Theoretically, the higher the risk you need to get to retain the investment. The lower the risk, the lower the average.
For investment securities, we can create a scheme of different types of securities and associated risk/reward profiles.
Determining risk preference
With so many different types of. investments to choose from, how does an investor determine how much risk they can handle? Each individual is different, and it is difficult to create a consistent model that applies to .everyone, but here are two important things you should consider when deciding how much risk you should take:
• Time horizon: Before making any investment, you should always determine how much time you should keep your money invested. If you have $20,000 to invest today. but need it in one year to get a down payment for a new home, investing money in high-risk stocks is not the best strategy. The riskier the investment, the more volatile or volatile the price. So if your time horizon is relatively short, you may have to sell your securities at a significant loss. With a longer time horizon, investors have more time to compensate for any potential losses and are therefore theoretically more high risk-tolerant.
• Finance: Determining how much money you can lose is another important factor in knowing your risk tolerance. This may not be the most optimistic way to invest; However, it is the most realistic. By investing money you can afford .to lose or afford for a certain period, you will not be pressured to sell any investments due to panic or liquidity problems. The more money you have, the more risk you can take.
Investment Risk Pyramid
After determining how much risk is accepted in your portfolio by recognizing your time horizon and funding, you can use the investment. pyramid approach to balance your assets.
This pyramid is considered an asset distribution tool, which investors can use to diversify their portfolio investments according to the risk profile of each security. The pyramid representing the investor’s portfolio consists of three distinct levels:
• Base of the pyramid: The foundation of the pyramid represents the strongest part that supports everything on top of it. This region must consist of low-risk investments with expected returns. It is the biggest space and includes the bulk of your assets.
• Middle Part: This region should consist of medium-risk investments that provide a steady return while allowing capital to increase. Although these investments are riskier than the assets that form the base, they must remain relatively safe.
• Summit: dedicated to high-risk investments, the smallest space in the pyramid (portfolio), and must consist of funds you can lose without any serious repercussions. Moreover, the funds at the top must be fairly disposable, so you will not have to sell prematurely in cases where there are capital losses.
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