Professionals in the investment industry talk about risk – a lot. Risk and return are inseparably linked, meaning that higher risk brings the potential for higher returns, and vice versa. You cannot expect the same type of performance from a low risk asset (like cash) and a higher risk asset (like equities).
As mentioned in our previous article, all investments have some type of risk. Even holding all your money in cash is not risk-free because cash exposes you to inflation risk – the risk that the interest you earn will not keep pace with inflation, and your money will be worth less over time. Some risks can be mitigated by proper diversification (business risk), while others are an unavoidable part of investing in the markets (market risk and interest rate risk).
These are just a few of the common types of investment risk. However, as you go about making daily financial decisions, there are other types of risk you probably never heard of or won’t be able to find in a textbook. Below are the three common ones.
1. Risk of FOMO (Fear of missing out) In the investment world, FOMO is extremely common when new stocks go public. Take GoPro (ticker: GPRO) for example. When GoPro stocks went public at $24 per share in June 2014, it was selling like hot cakes and amid the excitement it quickly rocketed up to a high of $98.47 by October of the same year, despite warning signs from Day 1. Today GoPro lingers around $5 per share. It’s a classic example of investor FOMO leading to an over-inflated price. The recent enthusiasm over bitcoin also looks like it is turning out to be a similar story. When an investment looks ‘hot’ and every major news outlet is talking about it, take a time out. Don’t use yourself as a guinea pig – let others do it for you, and then you can evaluate whether a certain asset is worth the investment and avoid the pain of wasted money if it was just a trend.
2. Risk of being a know-it-all. You know when the market is about to correct, you are certain when it is about to turn around and come back. You might be right – and that is actually the riskiest outcome of all because it leads to false confidence. No one can predict the future on a consistent basis. Even investment analysts (whose entire job revolves around predicting future earnings and setting price targets) are consistently wrong in bull and bear markets. A diversified index-based investment approach means you never need to consult your crystal ball to predict investment winners and losers – which is a good thing.
3. Risk of emotional investing. Investing based on emotions is never a good idea to begin with. Panic-selling in a falling market only locks in your losses and prevents you from buying investments while they trade at a discount. Buying into a bull market may mean you’re “buying at the top.” The best thing to do is to be consistent, no matter what the markets are doing. Keep your investment timeline in mind as well. Do not let short-term market downturns scare you from your long-term goals for growth. On the flip side, if your investment timeline is short and you require a more conservative allocation, do not let your excitement over a high-risk, high-return investment derail what you have built over a lifetime. The investment does not care whether you’re excited or not. You cannot base your investment decisions on this factor.
How much risk can you take in your investment portfolio? Risk tolerance is different for each investor. The basic rule of thumb is investors can afford to take on more risk for long-term goals, and less for short-term goals.
The Bottom Line
The goal is not to remove all levels of risk in your financial life, but to mitigate it where you can. Risk is vitally important because without it, there cannot be growth. But there is no need to bring unnecessary risk to the table. Investors must be careful to take only the risks they intend to take – the risks that do not endanger your current situation, but provide the opportunity to approach your future goals with fewer detours along the way.
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