By Carla Seely, Vice President of Pension and Investments, Freisenbruch.
Speak to anyone who has decided to go it alone and open a business, and you’ll discover that they understand the term “risk”.
My 98-year-old grandfather is one of those people. During his thirties, he opened a business from his backyard, and whenever I have spoken to him about it, he has always been honest: there were good times, there were great times, and there were times he wondered if he could put food on the table for his family. His greatest advice has always been “Without taking risk, whether in business or an investment, you truly cannot appreciate the power of determination.”
Firstly, you must have a good understanding of your risk tolerance; it is crucial to making a successful financial decision. Understanding how much risk you are willing to bear for the potential rewards or results is essential. What drives an investor’s willingness to take on risk depends on which of the four personality traits he or she possesses. Which one are you?
The Low Risk Taker
Cautious investors make decisions based primarily on feelings, and they are very sensitive to investment losses. Fear drives their investment decision-making process. They have trouble making proactive decisions regarding their investments and lack trust in investment advisors, rarely taking the advice of others. The portfolios of low risk investors usually consist of safe investments, with
the majority pacing below the rate of inflation and having a low turnover.
The Methodical Risk Taker
Methodical investors follow a disciplined, mechanical investing strategy. They make investment decisions based on hard facts and tend to complain about small details. They rely heavily on investment research and are not emotional about their investment decisions. These risk takers are consistent, they will look at a regular investment strategy, and they are firm believers in
“dollar-cost averaging”. You often find these investors will put additional voluntary contributions into their pension plan.
The Higher Risk Taker
Spontaneous investors make investment decisions based on feelings and do so frequently. These investors tend to always second-guess themselves and the advice of others, and often
chase the next big investment fad. Their investment portfolios usually exhibit high investment turnover and may include riskier investments.
The Individualist Risk Taker
Individualist investors make decisions based on hard facts and do not second-guess their investments. These investors exercise independent thinking and put a great deal of trust in their investment research. They also feel extremely comfortable working with wealth managers and tend to look at investment firms as opposed to their current bank that offers a “one-stop shop”.
So once you’ve determined your risk personality type, you need to completely understand the term “risk and reward” or, more importantly, “risk versus reward” – and it’s not that simple.
If you knew that you would be rewarded for taking on a risk, you would probably accept that risk. However, it is important to remember that the greater the reward, the greater the risk.
At the low-risk end is a Certificate of Deposit [CD] or term deposit, which is conservative and normally provides guaranteed investment income. If you place $10,000 in a CD, you are guaranteed to get back your principle of $10,000 plus the guaranteed income at the rate you chose to invest the money.
What if you use $500,000 and buy a $500,000 piece of property instead? At the medium-risk level, there are no guarantees: the value of real estate is dictated by what the next person is willing to pay for it. You may never see the $500,000 price again, but you still hold the tangible asset that is the land and building. But you stand to gain more if, for example, you clear some of the land and expose a view of the ocean. You will then be in a position to sell it for more than $500,000 simply by having added value through the new panorama.
Lastly, at the high-risk end, you decide to invest in gold as you have heard that it’s the next big thing. You also hear that the price may increase to as much as $5,000 per ounce, so you decide to buy gold stocks instead of coins or bars. You expect returns of 20–30 per cent, and you’re willing to take this riskier investment for the potentially higher return. However, gold prices drop and your gold stock tumbles as well, turning your expected gain of 20 per cent into a 20 per cent loss instead.
At the end of the day, understanding your risk tolerance is almost as important as understanding the investment itself. You may feel you have a high risk tolerance, but if it coincides with a rising market, you may soon discover that you have a low risk tolerance when the market softens.
If you would like any further details, please contact Carla at cseely@fmgroup.bm or call +1 441 297 8686.