Risk and more importantly your own risk profile is something most stock market beginners very rarely consider. Having a sound understanding of your risk profile will help you to determine which asset classes (cash, bonds, stocks, real estate, etc) are more suited to you.
So what is risk?
Risk can take on many different forms in the stock market. There is business risk, liquidity risk, market risk and inflation risk just to name a few. Before we can understand these more complex forms of risk, we must start with risk in its most basic form.
Risk, from an investment perspective, is simply defined as the variation of return. This is important to understand, risk is the amount of change (variation) in expected return. Another way you can look at risk is to simply consider it as the likelihood of loss (or less than expected return).
To better understand risk and return, let’s take a brief look at the risk and return relationship.
The Concept of Risk & Return
Low levels of risk are associated with potentially lower returns (low variation). On the other hand, high levels of risk are associated with potentially higher returns (high variation).
According to the risk-return trade-off, an investment can deliver a higher return only if it is subject to the possibility of being lost. In short, potential return rises with an increase in risk. Risk and return go hand in hand, but your expectations of return and the way you react to and respond to risk will depend on your risk profile.
Risk Profile
Your risk profile is basically how comfortable are you with different levels of investment risk? Different risk profiles are better suited to different types of investments. At one extreme is the risk adverse investor who is looking for the capital security offered by low risk investments (cash, fixed interest and Government bonds).At the other end of the spectrum is the risk seeking trader who is looking for high growth, high risk strategies (speculative stocks, options, futures and CFDs).
It is important to better understand risk and more significantly your risk tolerance. By being aware of your risk profile you can better:
- Appreciate the way you will respond to the various risks inherent in the stock market;
- Develop an investment or trading style that is right for you (rather than ‘buying’ someone else’s system which may or not be suited to you;
- Choose the type of stocks you’re more suited to invest in; and
- Determine an appropriate position size for each trade based on your risk tolerance.
Failing to appreciate risk and risk tolerance is a common problem for the large majority of first time stock investors and traders. By not having an appropriate level of knowledge and skill, the novice tends to seek out the ‘market guru’ for an appropriate stock trading strategy.
All too often these trading strategy fail in the hands of the beginner because the techniques learnt do not complement the beginners risk profile. Understanding risk and your risk profile is extremely important, but you should also appreciate that your tolerance to risk will change over time depending on your age, knowledge of the markets, investment objectives and whether you have dependants.
For more information on Risk and your Risk Profile download a FREE copy of my EBook “6 Crucial Decisions When Starting Out In The Stock Market” by submitting your First Name and Primary Email in the form to the top right of this blog.
