Why Is Taking Financial Risk Important?
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No matter where you are on your financial journey, controlling your finances is one of the most important things you can do for your future.
While it’s challenging to break the cycle of living paycheck-to-paycheck or find money to invest when you’re supporting kids or helping aging parents, building your own financial house must be a priority.
Unfortunately, you can’t just save money to build long-term wealth.
It may seem like the safest way to get ahead is to keep increasing deposits to your savings account. But your money won’t be making much money, especially if it's at a traditional bank.
You’re also risking your money’s future buying power to inflation, even if you have a high-interest online savings account.
That’s why it is essential to consider taking more financial risk – to achieve a greater return.
If you understand your risk tolerance and already have a diversified portfolio aligning with your financial goals, you probably don’t need this article.
But if you consider yourself risk-averse, conservative with your finances, or anxious about investing and losing money, we urge you to keep reading.
Your future self will thank you when your net worth grows along with your confidence.
What is Financial Risk?
According to the U.S. Securities and Exchange Commission’s Investor.gov website, risk is the “degree of uncertainty and/or potential financial loss inherent in an investment decision.”
“All investments involve some degree of risk,” even those appearing safe.
It may make sense to you that investing in just one asset class (buying shares in an individual company or only buying investment properties) is risky.
“Putting all your (financial) eggs in one basket” isn’t a wise thing to do.
But the Financial Industry Regulatory Authority (FINRA) explains that merely choosing to put your money in conservative products like Certificates of Deposit (CDs) and high-yield Money Market accounts is also risky as they may not earn enough to keep up with the rate of inflation – currently around 2%.
If you’re earning 2.1% interest on a CD and the rate of inflation is 2%, your money isn’t growing much.
And if your money is sitting in a “safe” savings account at a traditional bank (or worse, under your mattress), it’s earning little to no interest.
While a savings account or CD seems like a low-risk money move, losing buying power over time is still risky.
You’ll be able to buy less in the future (thanks to inflation), and your money still isn’t making you more money. And that’s the goal of investing.
Preparing To Take More Financial Risk
If you’ve been complacent about your financial future or worry your current saving and investing strategies aren’t going to help you meet your financial goals, there are plenty of things you can do to adjust your course.
But before you decide to put your money at “risk” for a higher return, you need to evaluate a few things:
- Current and Future Available Dollars. Do you currently have $100, $10,000 or $500,000 to invest? How much can you continue to invest each paycheck, per month, or year?
- Current and Future Financial Goals. Are you saving for a car, a house, an investment property, retirement, or a child’s education?
- Timeframe for Each Goal. 1-year, 3-years, 10-years, or 40?
- Financial Product Knowledge. How much do you currently know, or are you willing to learn about savings and investment products? Do you want to be a DIY investor, use a robo-advisor, or hire a traditional financial advisor?
- Personality/Mindset. Are you, by nature, a risk-taker? Or are extra-safety precautions more your thing? Do you hold an abundance or scarcity mindset?
Your age, net worth, and ability to earn future income are significant factors in determining your appropriate investment risk level. Now and in the future.
A 25-year old you will invest differently than a 40-year old or 65-year old you.
Determining When Risk Is Appropriate and When It’s Not
Before putting money into an investment, you want to consider your ability (financially and emotionally) to recover from a financial loss.
In addition to the level of risk and potential return any investment product carries, you’ll also want to consider any upfront or ongoing fees it requires.
Plus, you need to know how quickly you can access your money if you need to cash in on your investment.
General recommendations are not to risk emergency funds or savings for shorter-term goals (less than 3 years).
Because not only does investing reduce your ability to access your money fast, but it also means you could end up with less money than when you started. Sometimes a lot less.
There, of course, are exceptions.
Under the right circumstances, taking on some risk when investing for a specific short-term goal or even investing some of your emergency funds could be right for you.
To determine if taking on more risk is appropriate:
Assess Your Financial Health
If you aren’t tracking expenses or using a budget, you may be missing out on growing the gap between your income and how much you spend.
Making small changes in your spending can give you extra money to pay down debt, grow an emergency fund, or begin investing.
Are you ready to make significant changes?
Consider your housing, transportation, and food costs.
Making changes in these three areas may help you find hundreds of dollars (or more!) each month to invest for your retirement years.
If you can’t risk losing any of your money, you should reconsider your plan to invest.
If you have a 401k with a company match, make contributing to get the match a priority. You don’t want to lose out on “free” money.
Then, continue to build savings and reduce your debt load before increasing your contributions.
Finally, if you have loved ones who depend on your income, ensure you’ve taken steps to provide for them too.
While you hope nothing terrible will happen, consider protection such as life or disability insurance as you look at your overall financial wellness.
It may cost a lot less than you think for a product like term life insurance. But the peace of mind it will give you is priceless – especially if you want to start investing in some higher-risk assets.
Educate Yourself About Investing
It’s amazing how much information is at your fingertips when it comes to learning about investing.
Yet the volume of information you can find online is also overwhelming to many new investors.
Where do you start?
What should you read?
Who can you believe?
These are all great questions. Our most important advice? Avoid getting your financial information from only one source.
New investors can begin by learning some basic investing terminology and other investing concepts.
Below is a list of some of the main categories of savings and investment products.
Each has its own general level of risk/return. Within each category, specific products may carry more risk/provide more gain than others.
- Savings Accounts
- U.S. Savings Bonds
- Certificates of Deposit
- Money Market Accounts
- Mutual Funds/Index Funds/Exchange-traded funds (ETFs)
- Annuities/Whole Life Products
There are also many alternative investments (i.e., real estate, precious metals, artwork, cryptocurrency, etc.) you might consider when deciding where to invest your money.
Some investments will be passive, while others, like real estate investing, maybe more hands-on.
Educate yourself in anything of interest, and never invest your hard-earned cash in something you don’t understand.
Once you get more comfortable, continue reading articles, blog posts, and investing books to increase your knowledge.
- Debbie Sassen’s The $1K Investor is a great place to start – even if you only have a few hundred dollars to invest.
- Anxiety over investing can be eased with Julie Grandstaff’s book, Save Yourself: Your Guide to Saving for Retirement and Building Financial Security.
- And if it all seems too complicated, J.L. Collins shares strategies you can follow in the Simple Path To Wealth.
If you plan to work with a financial professional, make sure you understand how they make money.
Consider working with someone who has a fee-only fee structure when starting to get unbiased advice.
If you hire a financial coach, be sure to choose someone you're comfortable with and who has a track record of successful work with new investors.
Also, check references and consider their background knowledge and experiences.
Determine Your Financial Risk Tolerance
You’ve probably heard that the younger you are, the more risk you should take when it comes to investing.
When you have a lifetime ahead of you to earn more money and deal with economic downturns, you can afford to pursue higher returns.
But you also need to remember that personal finance is personal.
Your money “story” and emotions will impact the decisions you make now and in the future. And it takes time to build your investment philosophy.
Financial professionals or coaches, and even robo-advisors have tools or calculators to help you determine your level of risk tolerance.
You might be surprised to find out you aren’t as conservative as you think. Or the exact opposite!
There are also tools online, such as the University of Missouri’s Personal Finance Planning Investment Risk Tolerance Assessment.
Vanguard and most other investment websites offer free online questionnaires too.
After you answer the assessment questions, you’ll get targeted feedback about your level of risk tolerance.
Again, use more than one tool and compare your findings to determine the most accurate result.
Take Action and Revisit Risk
- taken a deep dive into your financial situation and future financial goals
- learned more about investing or worked with someone on developing an investing plan, and
- figured out your risk tolerance,
-it’s time to decide what to do about your investments and take action.
Whether you decide to start investing, change asset allocation to take more risk for a higher potential return, or stick with your current strategies, for now, you’re making progress toward building wealth for your future.
You’ll likely have more financial security by managing some level of risk. But only you can decide how much risk you’ll take for potentially greater rewards.
Once you determine a strategy, you’ll mostly want to “set it and forget it.” But this doesn’t mean ignoring it.
You don’t want to become so comfortable with your investment decisions that you fail to reconsider what “risk” means to you over time.
Diversification of your portfolio is key. Your risk tolerance may change as you age or deal with certain life situations. And get closer to–or eventually retire.
Managing Risk To Build Wealth
When you decide it’s time to take on more risk, you don’t have to rush to change your total investment strategy.
Time is a crucial factor in the magic of compounding. But making investment decisions before you're ready and understand them can backfire too.
Some people embrace risk by leaving all or most of their safe investments behind. Others will sacrifice higher potential returns for more security.
If a conservative approach helps you sleep better at night, investing more money for a lengthier period will build wealth too.
The important thing is you’ll be making decisions about how to invest for your future. Rather than being afraid to take action.
By assessing your financial health, you’ll know exactly where you stand with money. You won’t take on a risk just because someone tells you it’s important.
You’ll opt (or not) for investments with higher risk and greater potential returns because that’s part of your financial mission and investing plan.
Your mindset will shift over time from being fearful to courageously taking more risks.
You’ll be confident to ask questions, and you won’t panic in market declines. You’ll have what it takes to be a successful investor.
Next: Invest a Lot Of Money at Once or Spread it Out?
Written by Women Who Money Cofounders Vicki Cook and Amy Blacklock.
Amy and Vicki are the coauthors of Estate Planning 101, From Avoiding Probate and Assessing Assets to Establishing Directives and Understanding Taxes, Your Essential Primer to Estate Planning, from Adams Media.