Investing: Understanding Risk!!

In 2007 the Bahamas International Securities Exchange (BISX) produced a return of 23.3% – the highest return since the exchange came into existence in 1999. At that time investors were extremely pleased with the results. However, by the end of 2008, the exchange pulled back most of the gain of 2007 and was down (17.5%) at closing. As at September 4th, 2009, the exchange continues to fall and at closing, was down (10.56%). Looking at the returns that BISX earned between 2007 and the present shows that investing in the stock market can be a roller coaster ride. That’s why it’s important for anyone who wants to invest in the stock market to first gain an understanding of risk!

It is understandable that individuals new to investing find the subject overwhelming and somewhat confusing. Where do you start? Are there guidelines that I should follow? How do you make sense of it all? As indicated earlier, one of the first things that an investor should understand is risk. How do you feel about risk? Am I a high, medium or low risk oriented individual? The more you understand about risk, the more you will understand about investing in general.

Risk is a double edged sword. The larger the amount of stocks you own, the higher the potential for big returns. Risk, in no uncertain terms, means that you might not achieve those big returns, and you may not have the money when you need it. Investing offers no guarantee; otherwise there would not be any risk. Knowing this, investors try to always seek a good balance between risk and reward.

Controlling risk and maximizing potential returns for the chosen level of risk is the goal of your overall investment strategy. Your decision on how much risk you are willing to take is a personal choice. Risk management is as much a personal behavioral issue as it is an assessment of one’s individual needs and willingness.

Newer investors often overestimate their tolerance for risk. That is evident by the number of investors who abandon their strategy and bail out of stocks when the market starts to tank. So, how much of a loss is really going to keep you up at night pacing the floor?

Inexperienced investors move into defensive mode under stress and fall back on gut instinct, which quickly overrides the decision they made in good times.

Perception of risk is not constant. Risk may be perceived to be practically non-existent in good times and extremely high in times of market stress or personal emotional stress. If you have not been through a full market cycle, it will be very difficult for you to properly access your reaction in times of real stress.

Investors who are looking to invest in good market conditions often tend to focus only on returns. They don’t see any risk. If you can see the risk, then you can take measures to avoid it. Risk is all about surprises that can spoil your goals. So it is important to realize that your assumed risk tolerance level is likely to be lower under severe market conditions.

The level of risk you choose should be based on factors including age, job type and security, marital status, contingency plans, and any back-up resources you may have. Then these factors have to be balanced against your emotional tolerance for risk. If your needs don’t match your tolerance level, you are likely to dump your goals at the worst possible time.

The first thing to note is that the stock market is volatile and you cannot expect things to go smoothly all the time, nor can you rely on past behavior as a predictor of future results. When you have many years to go until you need your funds and you have a reliable income, larger percentage of losses may be tolerated. When your time-line is getting close, retirement for instance, you will want to reduce the risk to minimize any losses that may occur.

The risk of a worst-case scenario is real and should be respected; it can happen when you least expect it. While the stock market has provided exceptional returns over time, the ride can be a tumultuous one. If you don't buckle down, you may get hurt.