Once you have a sense of the money you can spare for investing, you’ll need to decide just how much risk to take with those funds. Unfortunately, all too often people skip this step and don’t follow proper investment advice. They think of investing money like gambling money. Once they decide how much they’re willing to play with, they’re willing to risk it all.
Investing vs Gambling
The second-largest tourist attraction in the world is Las Vegas. (The first, by the way, is Mecca.) And that’s no coincidence. Vegas is all about short-term thinking – the most natural way to think when it comes to money. In Vegas people roll the dice, spin a wheel, pull a handle, or play a hand, and voilà – instant gratification – win or lose!
The builders of the Vegas casinos knew how to stack the deck in their favor. Sure, there’s some skill involved, sometimes. But most of the time if you win it is because you are lucky. Most of the time people take huge risks and sustain huge losses.
If you want the instant gratification that comes with gambling, do it in Vegas. The only way to get immediate gratification in the markets is through extreme risk, like betting a bundle on one small up-and-coming stock or one white-hot sector. Extreme risk is like roulette: It offers a chance at a super-high return if you bet right, but there is also an extremely high chance of total wipeout.
The stock market is not a place to fool around with extreme risk. If you as an individual are going to invest your and your family’s money in the market, you should subject it to only reasonable risk. Reasonable risk is the degree of risk you need to take to give yourself the chance to reach your goals, and not an iota more. If you estimate it takes an 8 percent annual return for the next five years to reach a short-term goal, then your game plan should be comprised of investments that together offer the best chance of providing you with that 8 percent return. Any combination of choices that proves even one bit more risky than that, and you are needlessly subjecting yourself to the possibility of losing your money.
Think of it like taking a trip. Say you have four days to drive 1,000 miles to your destination. If you drive 60 to 65 mph, you’ll reach your destination in the time allotted. You’ll incur the risk of getting behind a wheel and the risk of driving 65. But because driving about 65 mph is necessary to your goal, and because a four-day trip is a reasonable goal, the four-day plan poses reasonable risk.
Say instead you’re eager to drive 80 to 90 mph. You’d arrive a lot quicker and perhaps would have a less tedious trip. But you’d boost your chances of getting a speeding ticket or having a serious accident. The higher-speed driving subjects you to risks that you simply do not need to accomplish your goal. Likewise, euphoric tech returns of 98 or 99 percent may be thrilling, but a subsequent crash is not.
Your Risk Tolerance
Do you know your risk tolerance? Are you risk averse? Risk steady? Or a risk seeker? If you don’t know, you need to have a feel for where you generally fit. You want to make sure there’s no gap between the risk you’re taking in your portfolio and your personal risk tolerance. Next, make sure you learn the top 10 Tips to Eliminate Risk.