Investing – Determine your risk tolerance

OK, you have read Robert Kiyosaki’s “Rich Dad, Poor Dad” and “Cashflow Quadrant”.  You understood that to achieve your financial success, you would want to be an investor (I Quadrant of the Cashflow Quadrant). 

You have some money, you want to invest.  What kind of investments would you go for?  High return investments which also carry high risk or low risk investments which has lower return?  Well, it depends on your risk tolerance level. 

Matthew Paulson has this to say about risk and investing.

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by Matthew Paulson

If you’re a savvy investor, you are naturally going to seek out the best interest rate on your money. If we were looking at interest rates and nothing else, we would head down to Vegas and put all of our money on double zeros, because after all it pays out 37 to 1! Of course we don’t do this because there’s too much risk involved. Other people are more focused on security, and choose to keep their money where there is no chance of losing it. This doesn’t mean we should go put it under a mattress though, because you are earning nothing in interest, and if the house were to go up in flames; all that money would be gone. Your financial life should not be devoid of any risk, but it should not take unreasonable amounts of risk either, it’s a matter of making sure the risks we take are reasonable, and appropriate.

There are some people who put way too much risk into their financial lives. They will do things such as buy a rental with zero money down, speculate in single stocks, invest in new companies, trade in currencies, borrow too much money, and not keep enough around for emergencies. If you let too much risk into your life, you are going find yourself in a world of hurt because things do not always turn out perfectly. Your rental could go un-rented, your investments could fail, and you could find yourself flat broke and possibly homeless.

There are also some people who don’t let enough risk into their lives. They invest in CD’s because they are guaranteed, settle for low paying secure jobs, and are unwilling to try new businesses or take another job. These people over insure themselves just incase something happens. These people end up losing a lot of money because they refuse to accept any risk.

So how much risk is appropriate? It is okay to take some risk in your financial life, but don’t take too much. Investing in things such as mutual funds is just fine to do, because even though there is some risk involved, they average 10% to 15% over long periods of time. You probably want to avoid extremely risky investments, such as unproven businesses, futures, options and the like. You will also want to avoid underperforming investments such as simple savings accounts and not investing the money at all.

You’ll want some reasonable insurance such as life, health, long-term care, and automobile, but you want to avoid gimmick insurances such as identity theft, credit life, and cancer insurance. It is fine to borrow some money here and there for things such as a mortgage, but don’t let your debt to income ratio be too high, because then you will be paying far too much as a percentage of your income in payments.

It’s all about optimizing the amount of risk you have. It can be done mathematically with the term Beta, that’s beyond most of our mathematical abilities. Accept some risk in your life, but not too much. Be reasonable!