How risky is your investment strategy?
There’s no such thing as a guaranteed investment — but some are a whole lot riskier than others. The rise of crypto and meme stocks in recent years has seen self-proclaimed investment gurus take to social media to promise endless riches to retail traders willing to take big risks — just as institutional investors pull out of volatile growth markets on fears of a looming global recession. In the current climate, how do you assess the riskiness of any given investment? And how much risk is too much when it comes to your wealth?
Investing is inherently risky. The key is knowing how much risk you’re willing to take on: Before deciding where an investor parks their capital, they must determine their own risk profile. This self-assessment lets you reflect on what your investment goals are and, crucially, how much you’re prepared to lose in their pursuit. Individual appetite for risk is a key component of this equation. A financial advisor can help you flesh out your personal risk profile in detail. For a rough idea, there’s no shortage of online risk profile questionnaires.
The size of your war chest will play a big role in determining your risk profile. Investors with a larger pool of capital to draw from have the leeway to take on some riskier plays. Heavyweight investors are better able to hedge — they can spread their capital across more and less risky investments, and will have a comfortable cushion to fall back on if the price of a shiny new asset goes south. For those without an infinite store of powder who are looking to manage and grow their life savings, caution is key. A more modest investor will want to minimize the risk of a loss that could jeopardize their ability to meet other financial obligations or imperil the future they’ve been working for.
The luxury of time also factors into this formula: Typically, the longer a person or entity is able to hold onto an investment, the better the outcome—and this is especially true for riskier assets like stocks, where riding out volatile market activity usually pays dividends over the long term.
The degree of risk varies depending on the asset: Broadly speaking, asset classes sit on a risk-reward spectrum that charts how safe they are compared to their potential returns. Leaving your wealth in the bank comes with little to no risk — but won’t give you the returns to secure your retirement. Bonds sit in the middle of the spectrum, offering higher income but exposing you to a certain level of risk, which increases the longer the term of the bond. Equities occupy the top-right corner of the chart — they’re more volatile since they’re subject to market risk, but historically offer the highest payout in the long term.
Alternative assets like cryptocurrencies and NFTs are even riskier but dangle the potential for astronomical returns—which for some investors has been a good enough reason to scramble to get a hold of the next big thing. That’s meant inexperienced retail traders have often ended up holding the bag, while larger movers make or break a new currency.
It’s not just poor risk assessment skills that can lead us to make bad investments: A whole host of psychological and emotional factors are at play when it comes to money management. FOMO (the fear of missing out), investor overconfidence, the sunk cost fallacy, and influence from peers are just some of the irrational behaviors that can lead to poor investor judgment calls.
Even the professionals struggle to get it right: Active investors — fund managers whose job it is to do the research and pick and choose securities on behalf of their backers — have historically not been able to match the returns of passive funds, which track the value of any given asset (the S&P500, for example) over time. Over a 20-year period, about 90% of index funds tracking companies of all sizes outperformed their active counterparts, according to one 2020 study. Even over a three-year period, more than half of index funds outperformed active ones.