Oct 16 2014

Risky Business

“The stock market is a casino.”
“Stocks are too risky.”
“I got burned once and I’ll never buy stocks again!”
Okay, who hasn’t heard these common refrains whenever stock investing comes up in a conversation? Yes, there IS risk when investing, so don’t get deluded into thinking anything one invests in is secure. But at the same time, don’t be so averse to risk that you think the stock market is fraught with risk and that any investment will fail (I know the crash of 2008 has NOT been forgotten).

If you make the time and effort to educate yourself, learn what the risks really are with a potential investment, and plan for a possible negative outcome, then you will go a long way towards minimizing risk and maximizing good choices. Rich Dad, Poor Dad author Robert Kiyosaki is often asked “Is X a good investment?” and his reply is “I don’t know. Are you a good investor?” That rhetorical question goes right to the heart of risk tolerance. If one invests based on a “hot tip” from your best friend’s cousin, a blurb in a newspaper article, or an article in some financial magazine without doing any deeper research (AKA due diligence), then of course investing is risky and that’s when it becomes akin to gambling.

If you want absolute safety and security, then just put your money into an FDIC insured savings account or CD and let it sit there. That silent killer, inflation, will steadily erode the buying power of the money and the interest it earns will be practically zero. The days of 5% interest have been gone for several years and it will be another several years until interest rates become as good. Sure, keep money in the bank for emergencies or a specific savings goal. But beyond that, accept some risk if you really want your money to work for you and not just sit there and let its buying power be slowly degraded by inflation.

In my view, a person’s risk tolerance is influenced by three major factors:

  1. Age. With age, one becomes acutely aware of the hard cold reality of having less time to recoup losses or attain financial goals. Being broke at 25 is scary, but being broke at 55 is utterly terrifying.
  2. Expenses/Obligations. Somewhat related to age, when a person has far greater expenses (mortgage, car payments, medical bills, etc.) and responsiblities (spouse, children, elderly parents) than somebody who doesn’t, then naturally one will be more risk averse.
  3. Savings/Net Worth. The less savings and net worth a person has, then the less discretionary funds one has available to invest and take calculated risks. When one’s savings and net worth are very very low, then the absolute preservation and protection of every saved dollar becomes paramount and the scarcity mindset totally dominates one’s world-view.

So what is your risk tolerance? Here are a few online quizzes I’ve found that can give you some insight into what kind of risk taker you are:

My risk tolerance has certainly changed as I built up my dividend income portfolio. Like many investor newbies, I was initially very risk tolerant and I was entranced by high yields (“Whoaaa! This investing stuff is a blast and the yields I’m getting kick ass!!”) and as a result my portfolio became heavily weighted towards a few high yield stocks, which has left me vulnerable to dividend cuts. It’s going to take time to correct course, but I can utilize one or more of the following methods to reduce my portfolio’s risk exposure:

  • Diversification. One way to blunt the damage from dividend cuts is to diversify and become less dependent on a few high performers. A portfolio of 20-25 positions is my ultimate goal. Anything more becomes too difficult for me to keep track of.
  • Divesting. With three (EXG, CFP, BGY) of my 14 stocks having a total weight of 49.4% of my total dividend income (yikes!), I recognize the need to either sell off some stocks to reduce my exposure or buy more stocks to reduce their weight.
  • Tax-free dividends. I’m investing more in tax-free municipal bond ETFs, which are less risky (only 3% of municipalities declare bankruptcy and bond holders go right to the front of the line of creditors to be paid should a bond issuer go bankrupt).
  • Growth dividends. Investing in dividend growth stocks should also help offset any dividend cuts to my high yielding stocks.

As long as you take calculated risks, fear will be less of an influence on your investing decisions.

Image Credit: AleksandarCucu (pixabay.com)