When most people think of investment risk, they may naturally think of the ones with a level of high risk only. All investments involve risk! The greatest risk of so called ‘safe’ investments, is their loss of value due to inflation. Let’s say you found a $1000 bill that had been hidden by your bank-hating great grandfather 100 years ago. He was saving it because he wanted to buy a fancy new car, but didn’t trust anyone to hold it for him as an investment. The bill itself is still only worth $1,000, but the new car will now cost close to $20,000. Great Grandpa’s mattress-money has lost a lot of purchasing power over the last 100 years. That is inflation, and that’s what happens when you don’t put your money to work for you.
The infographic gives you a general guideline on both the risk levels of various investments, and the maximum that should be held in each classification. It is important to remember that these risk levels are not rigid for each type of investment. For example, a mutual fund can be relatively low risk or very high risk, depending what it is holding for investments. Bonds with a AAA rating are much less risky than bonds with a B rating. Buying real estate can be very risky if the market is over-inflated, but less risky after a correction. Furthermore, there will be a lot of people that will not accept high risk and/or low risk investments, so their portfolio may have nothing in those categories of the pyramid.
FOMO (fear of missing out) can cloud judgement when deciding what level of risk someone is comfortable handling. Everyone ‘wants in’ when the price is going up, certain they understand and can handle the risk. But the true gauge of risk tolerance is how they feel and what they do, when the price starts going down. The fact is that most people buy high and sell low because their appetite for risk isn’t what they thought it was.
Your level of tolerance for risk may change over time. If you are young, your higher-risk investments may have 35 years to recover from a market downturn. However, if you are approaching retirement age, you may not want to risk a significant reduction in capital that you need access to in a few years. Even a timid investor may start accepting more risk when they realize how pathetic their guaranteed investments are doing.
Some people are so risk adverse, they never leave they bottom tier of low returns, and may find out too late they haven’t saved enough for retirement. What they don’t understand now is that an inadequate return on investment is putting them at risk of not achieving their long term goals.
Risk tolerance has been thrust into the spotlight with the explosive growth of cryptocurrencies and the even riskier Initial Coin Offerings (ICO). Aside from the fact that scams and other types of fraud are rampant, ICOs and their tokens are on the radar of securities regulators around the world, and the general consensus seems to be that most are operating illegally as unregulated securities. At this point, they are a high-risk speculative gamble. Read the ICO Module before investing.
Most cryptocurrencies fall into the extremely high risk category as well, because of pump-and-dump schemes (and other fraud), abandonment, flood of competition, no business model or experience, the risk of loss from poor security or exchange hacks, among other risks. Typical of start-up businesses, they will likely experience a 90% failure rate. However, there are some amazing cryptocurrency projects being worked on by dedicated leaders with vast experience in the business world. These are the ones that are already moving down the risk scale and will go on to be the blue chips of crypto.
Investments in new technology like cryptocurrency are both risky and volatile, but if you pick the right ones, the payoff can be huge. If you have done your homework (it’s a big assignment that has very little to do with a whitepaper), can tolerance the risk, and believe this project has what it takes for long term survival, you can start investing with just a few dollars if that is all you have. Still unsure? Ask yourself – Will I be more upset if I lose $100 because it fails, or if I don’t take a chance and it is blue-chip successful.
Education is key in making smart investment decisions in the cryptocurrency industry.
The reward for purchasing higher risk investments, is the potential for much higher profits or returns. The opposite holds true for low risk investments where the returns are usually very low. The smart investor has their holdings spread out across various financial products, companies, sectors, and risk levels. They make sure not to have excessive exposure financially to anything that is high risk, and in general, little to none, in the extremely high risk category. On the flip side of this, the savvy investor knows that too much held in low risk money/savings products can hinder long term wealth accumulation.
Extremely High Risk
Extremely High Risk investments are usually speculative in nature and should make up no more than a very small portion of your holdings – but only if you can stomach the risk. There should be very little, if anything at all, put into the extremely risky category unless you are a knowledgeable experienced trader, and/or using money you can afford to lose. While the potential reward increases with the level of risk you are willing to take on, these types of investments can result in a total loss. Can you sleep with that? If the answer is yes, then spread the risk out among several companies and across various sectors.
ICO’s (Initial Coin Offerings) have the dubious honor of top spot on our pyramid as the riskiest investment. There are likely some good quality ICO projects that are operating legally, but they are so drowned out by hundreds that are not, it is very difficult to find them. The ICO concept is brilliant, but the execution to date is not. ICOs need to be screened and vetted by unbiased professionals, as well as follow all existing laws on securities, before they become anything more than a speculative gamble. See the ICO module for more information.
Since most cryptocurrencies were launched without viable long term business plans, they will likely meet the same fate as the tech startup boom of the 90’s, with perhaps 10% still around when the dust settles.
What elevates an investment to the Extremely High Risk category? It is the risk of a total loss of capital.
- ICOs (Initial Coin Offering)
- Most Cryptocurrencies
- Penny stocks
- Junk bonds
The high risk category can present some good opportunities to increase the overall return of your basket of investments. Regular contributions every month to a diversified fund (even if it is high risk) is a much less stressful approach than putting in a lump sum into a single equity. You can get started in cryptocurrency with little or even no money at all. See the Cryptocurrency module for more information.
- Some Cryptocurrencies
- Hedge Funds
- Equities (common shares in individual companies)
- Some Mutual Funds
Medium Risk investments give the nervous investor the opportunity for higher returns with a conservative exposure to stocks, bonds, and real estate. Mutual funds that have a relatively balanced holding in different sectors, companies, and financial products offer the customer built in diversification.
- Conservative Mutual funds
- Preferred Shares
- Real Estate
On the low end of the risk pyramid are investment products that offer a guarantee of capital, but come with a very low return. Some of these products may be better classified as locked-in savings, since they accomplish very little in the way of wealth building. The biggest risk to these low return investments is inflation. People that put all of their money into low return products like this, may see inflation eat away at the very capital they were trying so hard to protect.
Investments with a guarantee of capital are a good idea if you need the money for something in the near future, such as a down payment on a house, or to pay living expenses for the next year or two.
- Money Market Funds
- Guaranteed Investment Certificates (GIC)
- Savings Bonds
- T-bills (treasury bills)
- Term Deposits