Investor psychology: how to successfully manage risk


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Website story by Paul Gregory

Risk sounds bad, but it’s a normal part of investing. Risk means taking a chance you won’t get the return you expect on your investment. Or of losing some or all your money.

But taking risk is what you get paid for. If you take on higher risk, you should get higher returns over time.

Risk should improve your overall chances of getting the return you need to achieve your goals. That’s the only reason for accepting risk.

So, risk is bad only if:

·         You take on too much (or too little) to achieve your investing goals.

·         You don’t get paid enough return for the risk you’ve accepted.

The funny thing about risk is the most uncomfortable situations are not necessarily the riskiest. For example, if share prices fall a long way for a long time.

There’s risk they could fall further. But if they have lost lots of market value, a large amount of the risk has already happened. Plus, the fall could also mean some of the shares, even a lot, are cheap.

If you take risk in those circumstances, you may get well paid. Potentially, very well paid.

Risk is in your head – and your stomach

But you would only do that if you need to – and can stomach it, whether you need to or not.

The two most important decisions about risk are:

·         How much do you need to achieve your goals? How far away are they, how big, how much money are you starting with, how much and how often will you contribute?

·         What are your deep-down fears and feelings about risk?  

The first calls for some planning. But the second calls for honesty and self-knowledge.

Even if you need to accept a certain amount of risk – perhaps because you have big goals – you may not be comfortable with the results.

Some people hate to lose any money. Some people hate uncertainty. Some people find investment decisions very hard, very boring, or both.

If that’s you, it won’t matter if your investment goes up and down a little, and as you’ve been told to expect. It won’t matter if, regardless of movements, you’re still on track overall to meet your goals.

It won’t matter because you’re not thinking about your destination. You’re too upset by the journey, the unpleasant sensation of what’s happening to your money right now.

You need to figure out if this is you. You may need some expert assistance to do that. You may need to think about other options, like:

·         Contribute more.

·         Push out how long you need to achieve your goal.

·         Reduce your goal.

Don’t put your eggs in one basket, and choose your eggs wisely

Another way to reduce risk is to make more than one type of investment. Investment professionals call it ‘diversification’. You might call it not putting all your eggs in one basket.

Different investments have different risks and act differently in the same market events. If some of your investments go down, some stay flat and some stay up, that reduces the overall movement of your money and any losses you might make. That’s the point.

Think of your investment portfolio as a package of risk and return. Every investment you make affects the ‘package’. A new investment should reduce the risk of the package, increase its return, or (ideally) both.